History
of Taxation on Derivatives in India
Prior to Financial Year
2005–06, no special provisions were there for trading of derivatives, in Income
Tax Act, 1961. Although derivatives contract have been traded on Indian stock
exchanges since 2000, but were considered as speculative transactions for the
purpose of determination of tax liability under the Income-tax Act. The Finance
Act, 2005 has amended the provision to section 43(5), with effect from assessment
year 2006-07, to provide that derivatives trading transactions would not be
regarded as speculative transactions, subject to the fulfillment of certain
conditions.
What is derivative
A derivative means an
instrument whose value is derived. It has no value of its own. Its price is
based on the underlying asset like
foreign exchange, currency, securities and commodities.
Derivatives of stocks and indices can be traded on Indian stock exchanges. The result of a derivative
transaction is a transfer or exchange of specified cash flows at defined future
points in time. The most popular form of derivatives
are futures & options (F&O).
As per the Securities
Contract (Regulation) Act, 1956, “A derivative includes
(a) a security derived from a debt instrument,
share, loan, whether secured or unsecured, risk
instruments or contract for differences
or any other form of security;
(b) a contract which derives its value from the
prices or index of prices of underlying
securities.”
Income
earned from sell of shares
Income earned from sell of shares
can be taxable under Capital Gain or Business Head.
(A) Under Business
Head
Where
transaction is not delivery based i.e. Intraday trading which may be
speculation transaction or non-speculation transaction.
What is Intraday Trading?
When stocks
are purchased and sold on the same day before the closing bell of the stock
market, it is called intra-day trading. Here, the traders have to square off
their trade on the same day. The profits from such purchase and sale are
pocketed by the traders. Therefore, in such trading, the shares are not
transferred to the Demat account of the trader. This means there is no physical
delivery on the purchase and sale of shares.
To perform
intraday trading, you need to have an active online trading account. Intraday
trading involves the buy/sell orders being specified by the person who is
involved in trading. The basic purpose of initiating orders is to close them or
square off before the closing of the stock market.
The income tax laws of India consider intra-day trading
as a speculative transaction and the resultant income or loss as speculative
gain or speculative loss, as the case may be. Further, everyone who is into
intra-day trading must offer profits from such activity as business income. You
can arrive at your business profits by considering your gross income from
transactions made during the year from your yearly transaction statement and
then reduce expenses - internet charges, Demat account charges, depreciation on
laptop, and broker's commission, among others -- relating to such trading
business from such income.
Income from
derivative trades are taxed as business income
According
to Section 43(5) of the Income Tax Act, 1961 (the Act) speculation transaction
means a transaction, in which a contract for the purchase or sale of any
commodity, including stocks and shares, is periodically or ultimately settled
otherwise than by the actual delivery or transfer of the commodity or scrips.
Income from
intra-day trading is considered as speculative income and taxed as per standard
slab. Section 43(5) of the Income Tax Act, 1961, deals with speculative
transaction. It states that a transaction of purchase or sale of a commodity
including stocks and shares settled otherwise than by actual delivery or transfer
of the commodity or scrip is a speculative transaction. In intra-day trading in
shares, there is no actual delivery as the shares enter and exit from the
trading account on the same date and it does not enter the demat account at
all.
Under Section 43(5), business income is categorized as
speculative or non-speculative.
(a) SPECULATIVE BUSINESS INCOME: Income from intraday equity trading is considered
as speculative.
(b) NON-SPECULATIVE
BUSINESS INCOME: Income
from trading Futures and Options (F&O), both intraday and carry forward,
are considered as a non-speculative business.
Derivatives which are exempted from the definition of
speculative transaction
Following
derivatives are exempted from the definition of speculative transaction:
(i)
Trading carried electronically on
screen-based system
(ii)
Through stock broker registered with
SEBI
(iii)
by banks or MF on a recognized stock
exchange
(iv)
Supported by time stamped contract
note indicating Unique Client Identity No and PAN
(B) Under Capital
Gain
Where
transaction is delivery based i.e. We actually take the delivery of shares
provided it is not his business.
Trading
in shares
(a) When
transaction is not delivery based i.e. intraday trading
Ø
Business Income
(i)
Speculation
(ii)
Non speculation
(b) When
transaction is not delivery based
Ø
Capital gain
Derivatives are “capital assets” within the meaning of
section 2 (14) of the Income Tax Act
Derivatives are securities as defined under section 2(h) of Securities Contract (Regulation) Act, 1956, and therefore, property with value. Derivatives accordingly are capital assets, unless held as stock-in-trade of business. Futures & Options are contracts representing a property of value capable of being acquired, held & transferred, and have all the important ingredients of Capital Assets. Both types of contracts create rights & obligations & carry their own values.
Derivatives are securities as defined under section 2(h) of Securities Contract (Regulation) Act, 1956, and therefore, property with value. Derivatives accordingly are capital assets, unless held as stock-in-trade of business. Futures & Options are contracts representing a property of value capable of being acquired, held & transferred, and have all the important ingredients of Capital Assets. Both types of contracts create rights & obligations & carry their own values.
Types
of Derivative Contracts
The most commonly used derivatives
are futures, options, forwards and swaps. These are briefly defined below:
A
futures contract means an agreement to buy or sell on a future date. In this contract one party agrees to sell to
the other party on a specified future date, a specified asset at a price agreed
at the time of the contract and payable on the maturity date. The agreed price
is also known as 'strike price'. In other words, a
futures contract is an agreement between two parties to buy or sell an
underlying asset at a certain time in future at a certain price. The underlying
can be a commodity, stock, currencies etc. These are standardized exchange
traded contracts. The buyers of futures contract are said to be in long
position whereas the seller in short position. A futures contract may be
squared off prior to maturity by entering into an equal and opposite
transaction. To trade in futures, one must open a futures trading account with
a derivatives broker and simply involves putting in the margin money. With the
purchase of a futures contract, the holder legally binds himself to buy the
underlying at a specific price and at some specific time in future.
The effect is to guarantee or hedge
the price. The hedging party protects himself against a loss, but also loses
the chance to make a profit. Unlike forward contracts, futures are usually
performed (settled) by the payment of difference between the strike price and
the market price on the fixed future date, and not by physical delivery and
payment in full on that date.
EXAMPLE : 1
'A' enters into a future contract to
purchase from 'B' shares of C Ltd. at Rs. 100 on 31st December. If for
instance, on 31st December, the price of C Ltd. is Rs. 90, then A will pay to B
Rs. 10 per share. If the price of C Ltd. is Rs. 120 then B will pay to A Rs. 20
per share.
An Option
contract is a further variation of a forward or future contract. Similar to a
future contract, the exercise of the option does not result into an actual
obligation to sell or buy the asset against the full price, but results in a
contract to pay the difference between the strike price and the market price on
the date of exercise of the option. The buyer of the option contract is
required to pay an upfront fee called option premium (consider it as the price
to be paid to the seller of the option contract for buying the right). The maximum loss that a buyer of the
option may suffer is the amount of the premium paid. The seller of the option,
on the other hand, has unlimited risk because the buyer can, by exercising his
option, insist on performance. There are two types of options:
(a) CALL
OPTION: It gives the holder the right but not the obligation to buy
an asset by a certain date for a certain price
(b) PUT OPTION: It
gives the holder the right but not the obligation to sell an asset by a certain
date for a certain price.
Example 2:
In example 1, if the price of C Ltd.
on exercise date is Rs 120, than A will exercise the option as he stands to
benefit from doing so. However, if the price falls to Rs. 90 then, he will not
exercise the option, thus restricting his loss to the amount of the premium
paid by him.
(3) Forward Contracts
They are the simplest form of
derivative contracts. Traders and investors who wish to hedge against their
future risks use the forward markets. This market is characterized by actual
delivery of the underlying asset in most cases at the pre-determined date. Such
contracts are used to hedge against price fluctuations.
A
forward contract is a contract between two parties, where settlement takes
place on a specified date in future at a price agreed today. Each contract is
customized and hence is unique in terms of contract size, expiry and asset type
and quality. One of the parties to the contract assumes long position to buy
the underlying asset and the other short position to sell the asset. The
forward contracts are normally traded outside the exchanges. Since a forward
contract is customized and are traded outside the exchanges, these are exposed
to counter party risk which arises from the possibility of default by any one
party to the transaction.
EXAMPLE :
'A' agrees to purchase from 'B' 100
shares of 'C Ltd.' on a fixed future date for a pre-determined price of Rs. 100.
Here, on the fixed future date, A will pay Rs. 100 to B and B will deliver the
shares of C Ltd. to A.
(4) Swaps
Swaps are private agreement between two parties to exchange
cash flows in the future according to a prearranged formula. They can be
regarded as portfolios of forward contracts. The two commonly used swaps are:
(a) INTEREST
RATE SWAPS:
These entail swapping only in the interest related cash
flows between parties in the same currency say floating rate with fixed rate of
interest.
(b) CURRENCY
SWAP:
These entail swapping both principal and interest between
the parties, with the cash flow in two different currencies.
KEY NOTE
Only Futures and Options derivatives instruments are traded
on the NSE. The futures and options trading system of NSE, called NEAT F&O
trading system, provides a fully automated screen based trading for Index
futures & options and stock futures and options on a nationwide basis. It
supports an order driven market and provides complete transparency of trading
operations. It is similar to that of trading of equities in cash market
segment. Since the launch of the Index Derivatives on CNX Nifty index in 2000,
the exchange currently provides trading in F&O contracts on 9 major indices
and 145 securities.
What are Futures and options (F&O)?
Futures and options on stocks and indices offered by exchanges such as NSE and BSE. A stock futures contract facilitates purchase or sale of a stock at a preset price for delivery on a later date. A call option on a stock allows you to purchase the underlier at a preset price on a future date, while, a put option allows you to sell the underlier. Normally, delivery is not taken or given on F&O segment, only the difference in buy or sell price at squarin.
Futures and options on stocks and indices offered by exchanges such as NSE and BSE. A stock futures contract facilitates purchase or sale of a stock at a preset price for delivery on a later date. A call option on a stock allows you to purchase the underlier at a preset price on a future date, while, a put option allows you to sell the underlier. Normally, delivery is not taken or given on F&O segment, only the difference in buy or sell price at squarin.
Difference
between forward and future contracts
The basic difference
between forward and future contracts is that in a forward contract, the entire
principal flows from one party to another i.e. exchange of assets take place.
In the case of future contracts, on the other hand, only the net differential
between the strike price and the market price on the date of exercise is
exchanged.
Meaning of Future and Options
(F&O) Trading
Future and
Options (F&O) Trading comprises of trading in
futures and options. They are classified under Derivatives. Derivatives are
securities whose value is derived from the price of an underlying asset.
Futures is a contract made on a
trading exchange to buy or sell a security at a predetermined price on a
predetermined date and specified time in future. Example: Investor who plans to
invest in gold can either buy physical gold or can trade in derivative of gold
i.e. enter into a futures contract to trade gold at a predetermined future
rate.
Options is a contract between buyer and seller which gives
the buyer a right to buy or sell the security on a specific date at an agreed
upon price. In Futures, the buyer does not have an option to cancel the
contract, thus he may earn profit or incur loss. Whereas under Options, the
buyer has the right to cancel the contract if he is incurring losses. Since the
buyer has this advantage of exercising right, the buyer is required to pay a
premium when he enters into the options contract. Thus, if the buyer cancels
the options contract he still has to pay the premium amount.
Levy of Securities Transaction Tax (STT)
Securities Transaction Tax (STT)
rates are applicable in relation to sale of a derivative transaction on a
recognized stock exchange:
|
S. No.
|
Taxable securities transaction
|
Rate
|
Payable by
|
|
1.
|
Sale of an option in securities
|
0.05%
|
Seller
|
|
2.
|
Sale of an option in securities, where Option is exercised
|
0.125%
|
|
|
3.
|
Sale of a futures in securities
|
0.01%
|
Seller
|
Maintenance of Books of Accounts
All the transaction carried out need
to be recorded. This includes buy/sell transactions, expenses like electricity
bills, demat charges, phone bills, advisory fee etc. In case a trader is
involved in multiple forms of trading in shares like intraday trading, F&O,
making investments in MFs, holding shares for more than twelve months from the
date of purchase, the business income from each of these must be declared
separately since the tax treatment differs based on the type of dealing. The
common expenses can be bifurcated depending on the proportion of time spent on
the various types of trades.
Treatment
of loss arising in F&O transactions
As the transactions
entered into in the F&O Market are treated as Non Speculative Transactions,
the loss arising out of F&O Transactions would be allowed to be set off
against all other incomes except Salary Income.
If the Loss is not set
off against the incomes of the same financial year, then such loss can be
carried forward and set off against future incomes. However, for the loss to be
carried forward and set off, the loss should be disclosed in the Income Tax
Return and the ITR should be filed before the due date of filing of income tax
return.
If the Loss is not
disclosed in the income tax return or the income tax return is not filed before
the due date – the loss would not be allowed to be carried forward. Loss
claimed in ITR filed after the due date of filing of Return as Belated Return
is not allowed to be carried forward.
Loss from intra day
transactions is called as speculation loss.
Calculation
of Turnover
Turnover of Futures = Absolute
Profit
Turnover of Options = Absolute
Profit + Premium on Sale of Options
Example
Mr. X buys 2 contracts of Nifty Futures at Rs.1000 on 20th
June. The contract expires on 10th July. Price on 10th July is Rs.500. Realised
Loss = 2 * 500 = Rs.1000
Mr. X sells 2 contracts of Nifty Futures at Rs. 2000 on 10th
July. The contract expires on 30th July. Price on 30th July is Rs.1000.
Realised Profit = 2 * 1000 = Rs. 2000
Turnover = Absolute Profit = 1000 + 2000 = Rs. 3,000
Turnover for derivatives
As per the guidance note on tax
audit, the turnover is determined as summation of absolute values of profits
and losses.
In turnover must be calculated, in the manner explained
below:
(i) The
total of positive and negative or favourable and unfavourable differences shall
be taken as turnover.
(ii) Premium
received on sale of options is to be included in turnover.
(iii) In
respect of any reverse trades entered, the difference thereon shall also form
part of the turnover.
Here, it makes no difference, whether the difference is
positive or negative. All the differences, whether positive or negative are
aggregated and the turnover is calculated. For computation of turnover of
futures, the total of positive and negative or favourable and
unfavourable differences shall be taken as turnover. Similar will be the case
pertaining to speculation income the total of positive and negative or
favourable and unfavourable differences shall be taken as turnover. This can be explained with the help
of the following example:
Example - 1
If the profit made by Mr. A is Rs
1,50,000 and loss is Rs 2,50,000, then the turnover will be sum of the absolute
values of profit and loss. Hence, the turnover will be Rs 4,00,000. (Rs
1,50,000 + Rs 2,50,000).
Example - 2
Mr B enters into two
transactions during the year. He purchased one lot of Nifty for Rs. 8,00,000
and sold the same for Rs. 8,50,000, thereby earning a profit of Rs. 50,000. He
purchased one lot of Reliance Industries for Rs. 9,50,000 and sold for Rs. 9,40,000,
thereby incurring a loss of Rs. 10,000. In the above case, the total turnover
would be considered as Rs. 60,000.
Example -3
|
Particulars
|
Calculation
|
Amount
|
|
Profit on sale of Futures
|
100 * 10
|
1,000
|
|
Loss
on sale of Options
|
200*10
|
2,000
(negative ignored)
|
|
Premium
on sale of options
|
200*290
|
58,000
|
|
Total Turnover
|
|
61,000
|
Business Income: If
you are trading in the stock market frequently (mostly non-delivery trade),
returns from it can be classified as follows:
(a) SPECULATIVE BUSINESS INCOME:
Profit
from intraday trading is categorized under speculative business
income. Tax treatment is similar to your
Business income tax. It is taxed as per the tax slab you fall in while losses
can be set off only against speculative gains.
(b) NON-SPECULATIVE BUSINESS INCOME:
Income from trading futures & options on recognized
exchanges (equity, commodity, & currency) is categorized under
non-speculative business income. Tax on share trading in such cases is similar
to your business income tax. The profits on F&O trading are taxed as per
the tax slab you fall in whereas losses on such F&O trading can be set off
against business profit.
Compute
income from F&O trading
There are two ways to
compute income from F&O trading
(a) Normal system of computation:
Income = sales – purchase – other expenses – depreciation
During 2019-20, Mr A traded in Nifty
many times. His purchases were worth Rs. 70,00,000 and sales worth Rs. 80,00,000.
On the face of it, the income of Mr A would be:
Rs. 80,00,000 – Rs. 70,00,000 = Rs. 10,00,000
But he also incurred several expenses
related to this business, including:
Subscription plan for receiving stock market tips: Rs. 3,000, Telephone and Internet bills: Rs.
20,000, Salary paid to employee(s): Rs.
2,00,000, Fee to CA for filing return:
Rs. 10,000 Other business expenses: Rs.
15,000
The total expenses were Rs. 2,48,000.
In addition, the depreciation on assets such as car, office furniture and
computer during the year was Rs. 1,25,000. So, the total income of Mr A from
the trading business would be computed as follows: Rs. 80,00,000 – Rs. 70,00,000
– Rs. 2,48,000 – Rs. 1,25,000 = Rs. 6,27,000.
Under this system, the income is
computed on actual basis and the taxpayer is required to maintain a record and
invoice for each and every expense made. Moreover, he is also required to
maintain all the books of accounts, profit and loss account as well as the
balance sheet.
Allowable expenses from Income from Futures and Options:
Taxpayers
who regularly carry out transactions with regards to Futures and Options
trading are permitted to claim the following expenses, since these can be
deemed to be expenses arising from the conducting of business:
(i) Postage
charges or fees
(ii) Travel
and conveyance expenditure
(iii) Telephone
or fax expenses
(iv) Internet
related expenses
(v) Depreciation
on any asset that has been used by the trader for business purposes
(b)Presumptive
system of computation:
Income =
assumed percentage of sales
It can become very difficult for a
small business owner to maintain so many records and to keep a copy of all the
invoices. Therefore, for small traders there is another option wherein no
records are required to be maintained and the tax is to be paid on an assumed
basis. This scheme is called presumptive tax and is explained below.
The small trader can disclose his
income at any level above 6% of turnover. Earlier, the minimum required to be
disclosed was 8% but this was reduced to 6% from 2016-17 onwards. As the
payment is always received in banks in case of F&O transactions, they can
disclose the income as 6% of turnover. The presumptive scheme of tax is only
applicable to traders whose annual turnover is less than Rs. 2 crore.
CBDT’s
Circular No.6/2016, dated 29.02.2016 – [F.No.225/12/2016-ITA-11]
Subject
: Issue of taxability of surplus on sale of shares and securities - Capital
Gains or Business Income -
Instructions in order to reduce litigation - reg.-
Sub-section (14) of
Section 2 of the Income-tax Act, 1961 ('Act') defines the term "capital
asset" to include property of any kind held by an assessee, whether or not
connected with his business or profession, but does not include any stock-in-trade
or personal assets subject to certain exceptions. As regards shares and other
securities, the same can be held either as capital assets or stock-in-trade/
trading assets or both. Determination of the character of a particular
investment in shares or other securities, whether the same is in the nature of
a capital asset or stock-in-trade, is essentially a fact-specific determination
and has led to a lot ot uncertainty and litigation in the past.
2. Over the years, the
courts have laid down different parameters to distinguish the shares held as
investments from the shares held as stock-in-trade. The Central Board of Direct
Taxes ('CBDT) has also, through Instruction No. 1827, dated August 31, 1989 and
Circular No. 4 of 2007 dated June 15, 2007, summarized the said principles for
guidance of the field formations .
3. Disputes, however,
continue to exist on the application of these principles to the facts of an
individual case since the taxpayers find it difficult to prove the intention in
acquiring such shares/securities. In this background, while recognizing that no
universal principal in absolute terms ca.n be laid down to decide the character
of income from sale of shares andsecurities (Le. whether the same is in the
nature of capital gain or business income), CBDT realizing that major part of
shares/securities transactions takes place in respect of the listed ones and
with a view to reduce litigation and uncertainty in the matter, in partial
modification to the aforesaid Circulars, further instructs that the Assessing
Officers in holding whether the surplus generated from sale of listed shares or
other securities would be treated as Capital Gain or Business Income, shall
take into account the following
( (a) Where the assessee itself,
irrespective of the period of holding the listed shares and securities, opts to
treat them as stock-in-trade, the income arising from transfer of such shares/securities would be treated as its business income,
( (b) In respect of listed shares and
securities held for a period of more than 12 months immediately preceding the
date of its transfer, if the assessee desires to treat the income arising from
the transfer thereof as Capital Gain, the same shall not be put to dispute by
the Assessing Officer. However, this stand, once taken by the assessee in a particular Assessment Year, shall remain applicable in subsequent Assessment
Years also and the taxpayers shall not be allowed to adopt a different/contrary
stand in this regard in subsequent years;
( (c) In all other cases, the nature of
transaction (i.e. whether the same is in the nature of capital gain or business
income) shall continue to be decided keeping in view the aforesaid Circulars
issued by the CBDT.
4. It is, however,
clarified that the above shall not apply in respect of such transactions in
shares/securities where the genuineness of the transaction itself is
questionable, such as bogus claims of Long Term Capital Gain / Short Term
Capital Loss or any other sham transactions.
5. It is reiterated that
the above principles have been formulated with t he sale objective of reducing
litigation and maintaining consistency in approach on the issue of treatment of
income derived from transfer of shares and securities. All the relevant
provisions of the Act shall continue to apply on the transactions involving
transfer of shares and securities .
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