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Tax treatment of physically settled derivatives unclear

Tax treatment of physically settled derivatives unclear
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First Published: Thu, Apr 21 2011. 01 10 AM IST
Updated: Sat, Jul 02 2011. 03 00 PM IST
Physical settlement of derivatives is now possible, with the Securities and Exchange Board of India permitting physical settlement and the Bombay Stock Exchange launching such physical settlement. Till now, under stock futures and options, even if you had bought or sold futures on a particular stock or had an option to buy or sell a particular stock, you could not choose to take or give delivery of the stock. It was only the difference between the transacted price and the price on the date of maturity (or squaring up), which would be paid to or received from you. Now instead of the derivatives transaction being settled by payment of differences, it may be settled by delivery of the underlying stock. Though one understands that physical settlement of derivatives has not yet really taken off, it is necessary to understand how such transactions would now be taxed.
There has been no specific amendment in the tax laws nor has any circular been issued by the Central Board of Direct Taxes (CBDT) to clarify the tax treatment of such physical settlement of derivatives. One, therefore, needs to understand the position in the light of the existing laws.
The issues are whether the futures and the physical transaction are two separate transactions, or whether they are part of one continuous transaction, whether there is a transfer when the derivative gets extinguished and delivery of a share is taken or given, with any gain or loss on the derivative to be recognized at that stage, and what is the cost of the share acquired pursuant to physical settlement of the derivative transaction.
To illustrate, take a case where you buy a futures contract in a company for Rs630, expiring in the last week of May 2011. Assume that the cash price of the company’s shares is Rs600 on the date of expiry and you take the delivery on that date. The questions that arise then are: Is the cost of your shares Rs630, or is there a loss of Rs30 on your futures transaction when your futures expire with the cost of the shares being Rs600?
It is only if the futures transaction and the acquisition of the shares are two separate transactions that one would need to compute the profit or loss on the futures separately, and treat the market value of the shares on the date of physical settlement as the cost of the shares. If the transactions of purchase of the futures and physical settlement are regarded as one single transaction, then the question of computing any profit or loss on the futures does not arise.
If one looks at the nature of the transactions, what is happening is that you are agreeing to buy shares at a future date with the price fixed now. That is the very nature of a futures transaction. Though a futures contract is a security which is separate and distinct from the underlying share, such distinction is only so long as the option of physical settlement is not exercised. The futures is a right to acquire the share. When physical settlement takes place, what is happening is that the right, which already existed, is being exercised. Such right merges into the share that is acquired. It cannot be said that you have given up the right and acquired a share instead.
For easier understanding, take a case where you book a motor car, by paying an advance of Rs50,000. When you actually take delivery of the car, you are purchasing the car. Till such time as you do not take delivery, what you have is merely the right to purchase the car. Can you say that you have exchanged your right to purchase the car for the car? Certainly not. All you have done is exercised your right to acquire the car. There is no profit or loss arising at that stage. The advance that you paid for the right also forms part of the cost of the car.
Therefore, in the example mentioned earlier in the column, no profit or loss on the futures transaction would need to be computed, but the cost of the share would be Rs630. If one had sold futures, the sale price of the futures would be the sale price of the shares delivered on physical settlement. Similarly, the premium paid on purchase of call or put options would have to be added to the purchase price or reduced from the sale price of the shares, where the options are physically settled.
Such tax treatment would also be consistent with the tax treatment of derivatives in other countries, such as the US or the UK. Given the tendency of income-tax officers in India to take extreme stands, one wishes that the CBDT would issue a circular clarifying such tax treatment, so that taxpayers are not put to unnecessary litigation.
Gautam Nayak is a chartered accountan
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First Published: Thu, Apr 21 2011. 01 10 AM IST