Taxation of Derivative Transactions

The year 2020 has passed away and this year might be called as the Covid Year in history, this year has given a lot of time for people to think about their lifestyle, food habits, spending habits and have given them ample opportunities to sharpen their skills, learn new skills and taught them the principle never spend too much and follow the discipline of regular investment which may help them in the time of crisis.

To curb the spread of Covid 19, almost all the countries of the world imposed the Lockdown for different periods worldwide hence, India also imposed the Lockdown in March which continued till the first week of May, 20. As per the various reports published it was estimated that more than 1.2 million Demat accounts of new investors were opened during the period of Lockdown and there was a rise of trading volume by an astonishing 53 percent volumes in April 2020 indicating existing and new investors started to trade in the securities market during the lockdown period.

New entrants in the securities market have traded in the derivative market, without knowing the implications of the derivative trading hence, this article is articulated to assist them to understand the taxation and method of computation of profits arising out of derivative trading.

Meaning of Derivatives

As per the definition of Investopedia 'A derivative is a financial security with a value that is reliant upon or derived from, an underlying asset or group of assets- a benchmark. The derivative itself is a contract between two or more parties, and the derivative derives it's the price from fluctuations in the underlying asset. The most common underlying assets for derivatives are stocks, bonds, commodities, currencies, interest rates, and Market Index.”

Income Tax Provisions on derivative trading

As per the provisions of section 43 (5) (d) and (e ) of the Income Tax Act, 1961

(5) "speculative 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:

Provided that for the purposes of this clause-

(d) an eligible transaction in respect of trading in derivatives referred to in clause (ac) of section 2 of the Securities Contracts (Regulation) Act, 1956 (42 of 1956) carried out in a recognized stock exchange; or

(e) an eligible transaction in respect of trading in commodity derivatives carried out in a recognized stock exchange, which is chargeable to commodities transaction tax under Chapter VII of the Finance Act, 2013 (17 of 2013), shall not be deemed to be a speculative transaction:

Provided further that for the purposes of clause (e) of the first proviso, in respect of trading in agricultural commodity derivatives, the requirement of chargeability of commodity transaction tax under Chapter VII of the Finance Act, 2013 (17 of 2013) shall not apply.

Explanation 1.- For the purposes of clause (d), the expressions-

(i) "eligible transaction" means any transaction,-

(A) carried out electronically on screen-based systems through a stock broker or sub-broker or such other intermediary registered under section 12 of the Securities and Exchange Board of India Act, 1992 (15 of 1992) in accordance with the provisions of the Securities Contracts (Regulation) Act, 1956 (42 of 1956) or the Securities and Exchange Board of India Act, 1992 (15 of 1992) or the Depositories Act, 1996 (22 of 1996) and the rules, regulations or bye-laws made or directions issued under those Acts or by banks or mutual funds on a recognised stock exchange; and

(B) which is supported by a time stamped contract note issued by such stock broker or sub-broker or such other intermediary to every client indicating in the contract note the unique client identity number allotted under any Act referred to in sub-clause (A) and permanent account number allotted under this Act;

(ii) "recognised stock exchange" means a recognised stock exchange as referred to in clause (f) of section 2 of the Securities Contracts (Regulation) Act, 1956 (42 of 1956) and which fulfils such conditions as may be prescribed and notified by the Central Government for this purpose;

Explanation 2.- For the purposes of clause (e), the expressions-

(i) "commodity derivative" shall have the meaning as assigned to it in Chapter VII of the Finance Act, 2013;

(ii) "eligible transaction" means any transaction,-

(A) carried out electronically on screen-based systems through a member or an intermediary, registered under the bye-laws, rules and regulations of the recognised stock exchange for trading in commodity derivative in accordance with the provisions of the Forward Contracts (Regulation) Act, 1952 and the rules, regulations or bye-laws made or directions issued under that Act on a recognised stock exchange; and

(B) which is supported by a time stamped contract note issued by such member or intermediary to every client indicating in the contract note, the unique client identity number allotted under the Act, rules, regulations or bye-laws referred to in sub-clause (A), unique trade number and permanent account number allotted under this Act;

(iii) "recognised stock exchange" means a recognised stock exchange as referred to in clause (f) of section 2 of the Securities Contracts (Regulation) Act, 1956 (42 of 1956) and which fulfils such conditions as may be prescribed and notified by the Central Government for this purpose;]

As per the above definition of the Income Tax Act it is evident that transactions entered in the derivatives on the notified recognized stock exchanges i.e NSE, BSE, MCX etc are not speculative transactions in accordance with Income Tax Act, 1961 and it falls under the category of normal business activities carried out by the person. The Income Tax Act has defined the head of the income wherein income from such transactions shall be computed however, it doesn't defy how the income/turnover which is the most important aspect for computing the income under the head profits and gains from the business.

The Institute of Chartered Accountants of India in it's guidance note on tax audit has given a glimpse of the method of computation of turnover and profit for the transactions entered in derivatives which are as under:

Derivatives transactions are completed without the delivery of shares or securities. These are also squared up by the payment of differences. The contract notes are issued for the full value of the asset purchased or sold but entries in the books of account are made only for the differences. The transactions may be squared up any time on or before the striking date. The buyer of the option pays the premia. The turnover in such types of transactions is to be determined as follows:

i. The total of favorable and unfavorable differences shall be taken as turnover.

ii. Premium received on sale of options is also to be included in turnover.

iii. In respect of any reverse trades entered, the difference thereon should also form part of the turnover.

Example

Mr. X has entered into the following transactions during the fy 2020-21 on NSE and summary of transactions entered during the year as per broker records are as under:

Calculation of Turnover and profit in accordance with Income Tax provisions read with ICAI guidance note:

Particulars Turnover Profit

1. SBI 220 Call option 60000 60000
2. SBI 190 Put Option 30000 (30000)
3. Nifty 50 Future 675000 675000
4. Nifty 50 Future 675000 (300000)

Total 1440000 405000

Mr. Y has entered into the following transactions during the fy 2020-21 on NSE and summary of transactions entered during the year as per broker records are as under:

Calculation of Turnover and profit in accordance with Income Tax provisions read with ICAI guidance note:

Particulars Turnover Profit

1. SBI 220 Call option 60000 60000
2. SBI 190 Put Option 60000 (60000)
3. Nifty 50 Future 675000 (675000)

Total 795000 (675000)

In the second Example the person has incurred a loss amounting Rs. 6,75,000 and the turnover in accordance with the guidance note issued by ICAI is Rs. 7,95,000. Section 44 AD may get attracted in the above situation and the person may be required to declare income amounting to 6% of the total turnover computed above otherwise the person is required to get his books of accounts audited by a chartered accountant and may require to maintain all the records in respect of those transactions.

Concluding Remarks

While investing or trading in derivatives every person shall understand the taxation of such transactions before entering into such transactions and the opinion expressed above are of general nature, and for information purpose only, one should consult his tax advisor before forming a conclusive opinion about taxation of such transactions.