Taxation - All about F&O Taxation in India

Taxation on F&O

Most of the Indian Taxpayers irrespective of their earnings through business, jobs, services, indulge in Share trading because it is the quickest way of earning handsome money. It is therefore, necessary to know the taxation on the earning from share trading. But, before going into the taxation part, first it is important to understand what type of share trading activity you are indulging in, whether it is Taxable as Business Income or not.

Income from Futures & Options (F&O) is treated as an income from business and profession under income tax act, 1961. Thus, any profit or loss arising from Futures & Options will be assessed under the head of Income from Business and Profession irrespective of assessee being engaged in any other business or not. Since F&O income is treated as Normal Business Income not speculative income, Rate of Tax shall be same as normal rates applicable to an Individual.

Till assessment year 2005-06, the Income Tax Act, 1961 did not have any special provisions dealing with taxation of derivatives transactions in general, and dealing with futures and options in particular, though derivatives contracts have been traded on Indian stock exchanges since 2000. 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 fulfilment of certain conditions.

Whether Always Taxable as Business Income

The most common issue that arises in taxation of derivatives transactions is that of whether derivatives transactions are always to be regarded as business transactions.

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 are 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.

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.

If derivatives transactions are business transactions, the question then arises as to what constitutes the turnover in derivatives transactions for the purposes of section 44AB or for other purposes?

In the case of futures, the purchases of futures are not recorded as a purchase in the books of account, nor are the sale of futures recognized as a sale. Only the initial margin and mark-to-market margins are recorded as and when paid, and the profit or loss on the futures transaction is recorded as an income/expense on squaring up of the transaction or on expiry of the futures contract.

The margin paid is certainly not the turnover, and neither can the futures sale be regarded as a sale in the light of such accounting treatment. At best, only the difference (profit or loss on the futures transaction) can be regarded as turnover.

The question then is – should one net off the profits and losses and is only the net profit or loss to be regarded as the turnover? This does not appear to be proper, as the net profit or loss would not reflect a measure of the actual volume of transactions. It should be the gross differences which would constitute turnover, and not the net differences. The scrip wise gross differences for each maturity should be determined, the negative signs of the losses within scrip of each maturity ignored and such losses grossed up with the gains to compute the turnover.

In the case of options, only the premium and margins paid is reflected in the books of account at the inception of and during the currency of the option. The strike prices of the margins do not get reflected in the books of account, except for the limited purpose of identifying different sets of options. On the squaring up or expiry of the options, the value of the option on sale or maturity is received or paid, and the profit/loss on the options accounted for. There is a view that such value of the options on squaring up/maturity would constitute the turnover in case of options, though the better view seems to be that it would be the gross differences, as in the case of futures that would constitute the turnover.

This post was written with the help of Kumar Verma & Associates, a reputable CA firm established in New Delhi.