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derivatives as a capital asset ??

Rahul Bansal (article assistent) (36 Points)

12 March 2010

Q. Whether derivatives can be considered as capital assets for the purpose of capital gains ? in other words, whether the gain/loss from derivative trading can be considered as capital gain/loss ?

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CA Ayush Agarwal (Kolkata-Pune-Mumbai) (27191 Points)
Replied 12 March 2010

From My Side, This is Non Speculation Business.........No Capital Gain/Loss......

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Rajat Singhal CA,CS,CFA (Senior Manager (F&A)) (254 Points)
Replied 12 March 2010

Dear Rahul,

The Finance Act 2005 has amended the proviso to section 43(5), with effect from Assessment Year 2006-07, to provide that derivatives trading transactions would not be regarded as speculative transactions,

Therefore, the income derived from derivatives is an income from non speculation business.

It is true that in most cases, derivatives transactions would be regarded as business transactions on account of the following factors:

1.The purpose behind entering into most derivatives transactions is to profit from short-term fluctuations in market prices.

2.The period of any derivatives transaction cannot exceed 3 months, and such transactions are invariably short-term transactions.

3.Often, the sheer volume of trades in derivatives transactions entered into by a person on an ongoing basis indicates that it amounts to a business.

4.Many people who trade in derivatives may be associated with the stock market in some way or the other – they may be stock brokers or their employees, or regular day traders. For such people, derivatives trading is an extension of their normal business activities.

However, the issue of whether an activity amounts to a business or not depends upon various factors, and is not decided just because of the existence or absence of any one circumstance. There can be situations where derivatives transactions may not amount to a business. For instance, derivatives transactions may be carried on by an investor to hedge his investment portfolio. In such a case, the mere fact that the investor had to square up his derivatives position every 3 months and take up a fresh position, or pay mark-to-market on a daily basis, would not detract from the fact that the prime purpose of such transactions was to preserve the value of the investment portfolio.

Another common practice in the stock markets is arbitrage between the cash market and the futures market. It is a well known fact that the difference in prices between the futures market and the cash market is primarily dictated by the short-term interest rates, and such difference is normally equivalent to the interest that one would earn on short term lending. Therefore, a person having surplus funds may buy shares in the cash market, while simultaneously selling an equal amount of futures of the same share in the futures market. He would take delivery of the shares bought in the cash market. On maturity of the futures, the shares bought in the cash market would be sold in the cash market. Since the futures would be squared off at the cash market price, the profit on the transaction would normally consist mainly of the difference between the initial purchase price in the cash market and the initial sale price in the futures market, with small adjustments for expenses such as brokerage, securities transaction tax, service tax and the market spread between the buying and selling quotes in the cash market.

Are such arbitrage transactions business transactions, or are they really in the nature of interest seeking transactions? If one looks at the substance of these transactions, they are not motivated by a desire to earn profits, but just to avail of the benefit of the short term interest rates. There just two legs of the transaction – the purchase and futures sale, and the expiry of futures and cash sale. The income element in the transactions is determined right at the outset, and does not fluctuate to any material extent, even if there is substantial volatility in the market. Going by the principle of the substance of the transaction, a view is possible, as was being taken in the past in the case of vyaj badla transactions, that such transactions are in the nature of earning of interest, though they take the form of arbitrage transactions.

It may be however noted that other factors, such as frequency of transactions, nature of other business carried on, etc., would also determine whether such transactions are business transactions or not.

If not Business Income, under which Head Taxable:

The question arises that in a situation where derivatives transactions are not business transactions, under which head of income should such transactions be considered?

The answer to this question would partly depend upon the substance of the transactions. If the transactions are in the nature of interest-seeking transactions, then going by the substance of the transactions, the income from such transactions may be considered as interest.

But if the transactions are in the nature of hedging of investments, how would they be taxed? A derivative, being a security and a right under a contract, is certainly a valuable right, which is capable of being assigned. The right under the derivatives contract can therefore certainly be regarded as property, and therefore as a capital asset.

The issue which arises is – is there a transfer of the capital asset? When the transaction is squared up by an opposite corresponding transaction, there is certainly a transfer. But in cases where the squaring up is on expiry of the contract, can a transfer be said to have taken place? Considering the definition of “transfer” in section 2(47), the expiry of such a contract can possibly be regarded as an extinguishment of the rights in the asset. As held by the Supreme Court in the case of CIT vs. Grace Collis 248 ITR 323, the definition of “transfer” in section 2(47) clearly contemplates the extinguishment of the rights in a capital asset distinct and independent of such extinguishment consequent upon the transfer itself. A view is therefore possible that on expiry of the derivatives, there is a transfer of the capital asset. The gains or losses arising from such derivatives would accordingly be taxable under the head “Capital Gains”.

Though such income would be taxable under the head “Capital Gains”, and the derivatives transactions would be subject to Securities Transaction tax, such gains would not be entitled to the concessional tax treatment for short-term capital gains under section 111A, since the benefit of that section is available only to equity shares in a company or a unit of an equity oriented mutual fund.

Regards

Rajat

3 Like

CA. RUPESH JOSHI (Chartered Accountant) (174 Points)
Replied 12 March 2010

Good explanation - Rajat.

1 Like

CA Ashok Kumar Sahu (Partner) (3637 Points)
Replied 13 March 2010

good explanation by rajat, i'm agree with him.

Aakash (Innovator.) (21 Points)
Replied 28 July 2011

Hello CA folks, I request you to help me understand my tax liabilities here. I dont work for any organization nor do I own a business. I'm above the age of 18 and I only trade in the derivatives segment on NSE, using a broker - India Infoline (IIFL). Mostly, I trade in Options wherin I make a profit of 2.5% - 3.00 % pm (on an average) on invested capital. Do I need to pay taxes on these returns? If yes, what is my tax liability? Please keep it very simple. Thanks a ton for the information Rajat - it was very clear.

Regards,

Aakash