A question that many taxpayers ask is what would be the tax treatment of their earnings from transactions in derivatives of securities, such as stock options or futures or index options or futures. The issues that arise are with regard to the head of income under which such income is taxable—whether such derivatives gain or loss are to be considered as business income, capital gains or income from other sources, whether loss in derivatives are to be treated as speculation loss, and how the income from derivatives is to be computed when there are unsettled derivatives transactions at the year end.
If you are a trader in shares, and the derivatives transactions are an extension of your share trading activity, the derivatives income would also be regarded as business income, in the same manner as your share trading income. The issue is more complex in the case of an investor in shares, who has also transacted in derivatives. One then has to independently verify the nature of the derivatives transactions.
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If the derivatives transactions are frequent in nature and unrelated to the shareholding or the share transactions, generally such derivatives transactions would be regarded as having been carried out for earning short-term profits and income from such transactions would, therefore, be taxable as business income.
But where the derivatives transactions are closely linked with share investments, say, hedging transactions to safeguard against fall in share prices of existing share investments, one can’t say that the derivatives transactions are in the nature of a business. The issue then is: whether income from these transactions would be taxed as capital gains or as income from other sources? While it is possible to take a view that the income from such derivatives transactions is taxable as capital gains, it is possibly a safer approach to treat such income as income from other sources. In any case, the rate of tax for both these types of income is the same (your slab rate) since the capital gains are short-term capital gains on securities other than equity shares or units. Therefore, other than for the purpose of setting off of loss, there is no difference if such income is taxed as capital gains or as income from other sources.
If derivatives transactions are not in the nature of business, one does not need to verify whether the loss from derivatives transactions is to be treated as a speculation loss, since it is only the loss of a speculation business which is subject to the prohibition on set off against any other income. Normally, a transaction for purchase or sale of stocks and shares which is settled without delivery is regarded as a speculative transaction. If such transactions constitute a business, then the loss from such business cannot be set off against any other type of income. Derivatives, so far, are necessarily cash-settled. In other words, settled without delivery by payment of differences between the initially transacted price and the final price.
There is, however, a specific exclusion for exchange-traded derivatives in shares and securities from the definition of speculative transaction. Derivatives transactions carried out through a registered broker on a recognized stock exchange are not to be regarded as speculative transactions. Only three stock exchanges are so far recognized for this purpose—Bombay Stock Exchange, National Stock Exchange and, from 25 February 2011, United Stock Exchange. Therefore, loss from derivatives transactions in securities are generally not to be treated as speculation loss, and can be set off against other permissible incomes, depending on the head of income under which such loss falls.
In case of settled derivatives transactions, obviously the gain or loss is determined, and has to be taken into account while computing your income.
In case of unsettled derivatives transactions as at the year end, how is the income to be computed? Can one mark to market the unsettled derivative, and factor in the loss on such derivative if any, while ignoring the profit? When you compute income from derivatives transactions as business income or as income from other sources, your computation has to be in accordance with the method of accounting that you follow and in accordance with accounting pronouncements. Currently, applicable accounting pronouncements require you to book the mark-to-market loss, but ignore any mark-to-market profit. You would, therefore, have to follow this principle while computing your derivatives income. Do keep in mind, however, that these accounting pronouncements are likely to undergo a change in the next year or two. If that happens, you may also be required to book mark-to-market profits as at the year end.
All in all, while the subject of derivatives itself is complex, the manner of taxation of derivatives transactions is also fairly complex.
Gautam Nayak is a chartered accountant.
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