In this column, the subject of taxation of security derivatives and commodity derivatives has been dealt with earlier. As seen in those articles, there is a significant difference in the tax treatment of security derivatives and commodity derivatives. So what about the taxation of currency derivatives?
At first, one may be inclined to treat currency derivatives in the same manner as commodity derivatives. However, currency derivatives are traded on stock exchanges in the same manner as security derivatives, and are not traded on commodity exchanges the way commodity derivatives are. Currency derivatives cannot be settled by physical delivery, but can only be cash settled; in other words, settled by payment of differences. Given these differences, are currency derivatives to be treated for tax purposes in the same manner as security derivatives or as commodity derivatives are treated? Are the transactions of trading in currency derivatives to be regarded as speculative transactions?
Under commodity derivatives?
Since the definition of speculative transaction refers to a contract for the purchase or sale of any commodity, including stocks and shares, the first issue which needs to be addressed is whether foreign currency is a commodity or not. There is an old decision of the Court of Appeals in England, where the court has taken the view that foreign currency is a commodity. The tribunal in India has followed this view in the context of other assets, though there is one tribunal decision which has taken the view that foreign currency is not a commodity.
The matter, therefore, seems to be slightly debatable, though the better view seems to be that currency is a commodity, since it has physical existence and can be the subject matter of trade. If that is the position, a currency derivative transaction would be covered by the main part of the definition of speculative transaction. Would it fall within any of the exceptions to that definition?
One of the exceptions is in relation to certain types of hedging transactions. This exception, however, applies to contracts in respect of raw materials or merchandise entered into by a person in the course of manufacturing or merchant business, to guard against loss through future price fluctuations in respect of contracts for the actual delivery of goods manufactured by him or merchandise sold by him. Currency derivatives transactions are certainly not contracts in respect of raw materials or merchandise, and, therefore, this exception may not apply.
Also read | Gautam Nayak’s earlier column
The definition of speculative transaction under the tax laws has an exception for transactions in respect of trading in derivatives referred to in section 2(ac) of the Securities Contracts (Regulation) Act (SCRA) carried out on recognized stock exchanges. The larger issue therefore is whether a currency derivative is a derivative as defined under SCRA. Currency derivative transactions are carried out on stock exchanges, and not on commodity exchanges and would, therefore, not be regarded as speculative transactions if they qualify as derivatives defined under SCRA.
Under security derivatives?
The definition of derivatives under SCRA is fairly broad and would include all sorts of derivatives, and not just derivatives whose value is linked to underlying securities. In fact, even commodity derivatives would be derivatives as defined under SCRA, but for various reasons, commodity derivatives are not traded on stock exchanges but on commodity exchanges. The very fact that currency derivatives are traded on stock exchanges indicates that they are securities, one type of security being a derivative. Currency derivatives would, therefore, qualify for tax treatment in the same manner as security derivatives.
Accordingly, profit or loss derived from trading in currency derivatives would not be regarded as speculative income or loss, but would be treated in the same manner as any other business loss. Also, commodity derivatives trading losses or day trading losses, which are classified as speculation losses, cannot be set off against income from trading in currency derivatives, which is treated as regular income.
Are they business transactions?
Of course, so far as the issue of whether transactions in currency derivatives constitute a business or not, since currency derivatives are normally cash settled and are not capable of physical settlement, and the life of currency derivatives does not exceed 12 months, generally transactions in currency derivatives would be regarded as business transactions. This would be the position particularly where currency derivatives transactions are entered into as part of normal business transactions, such as to hedge business transactions. Today, most transactions in currency derivatives are entered into by businesses for hedging purposes and, therefore, in such cases there is no doubt that the currency derivatives transactions would be treated as part of normal business transactions.
As business transactions, the derivatives could be marked to market at the year end, and losses, if any, recognized while computing business profits, with gains being ignored. There could of course be exceptional cases where the transactions are entered into by individuals and may not be related to the business, and one could perhaps classify them as income from other sources in such cases. In either case, the applicable tax rates would be the same.
With high volatility in the foreign exchange markets over the last couple of years, currency derivatives are risky products. Fortunately, the tax treatment of the income or losses from currency derivatives is not so risky!
Illustration by Shyamal Banerjee/Mint
Gautam Nayak is a chartered accountant.