Derivatives

A derivative is a financial instrument, the value of which depends on the value of its underlying asset. These derivative instruments are of various kinds. A forward contract is an agreement to buy or sell an asset at a fixed future time for a particular price.

These contracts are not traded on any exchange. However, apart from this difference, the other difference is that in a futures contract the exactdelivery date is not specified. Options, the other kind of derivative instruments, are of two types. Call option gives the holder the right to buy the underlying asset by a certain date for a certain price. The put option gives the holder the right to sell the underlying asset by a certain date for a certain price. These options can be exercised only on the fixed expiration date in the European style, while in the American style, it could be excised even prior to the expiration date.

In markets abroad, a regulated derivative market provides for management of risks in the financial markets akin to the commodity futures markets. However, in India, at present the proposal to introduce the derivative trading is being actively pursued. In this connection, the various taxation issues which could be thrown up are being enumerated below.

Derivatives - definitions

The derivative instruments have not been clearly defined in any statute in India, except for the definition of the term `options' in Section2(h) of the Securities Contracts (Regulations) Act, 1956. It has been defined as contract for the purchase or sale of a right to buy or sell or a right to buy and sell, securities in the future and includes a put and/or call in securities. As seen above, derivatives are basically contractual rights or interests.

The Income Tax Act, 1961, has not defined these instruments anywhere in the act. The definition of speculative transaction in section 43(5) of the Income Tax Act, 1961, covers only commodities, stocks and shares, but does not cover derivatives or trading in any contractual rights or interests. Hence, in order to avoid any confusion, it would be required that the provisions relating to these transactions, ie, Section 43(5); Section 73, etc, be amended.

Derivatives trading - could it be covered under the definition of `speculative transaction'

Speculative transaction, as per the Income Tax Act, 1961, means a transaction in which a contract for the purchase or sale of any commodity,including stock and shares, is periodically or ultimately settled otherwise than by the actual delivery or transfer of the commodity or scrip.

Derivatives are no real security. Their value is derived from the value of the underlying asset. However, in case of index-based futures, as is being planned to be introduced in India, the underlying security/asset is the stock index. This index is neither an asset nor can it be delivered. Hence, these transactions are but naturally going to be settled other than by delivery.

In such cases, the transactions in these futures are bound to be categorised as speculative and the consequence of setoff and adjustments of income/loss, etc, would follow. In case of the other futures, let us say, based on a particular scrip, unless the contract is settled by actual delivery, these transactions would automatically fall within the purview of the definition of speculative transaction as per the Income Tax Act. It is therefore, required that the CBDT identify whetherderivatives are an asset or a security. If they are classified as an asset then the issue of speculation is taken care of, while if they are treated as security then the issue of whether the dealing in them would be treated as speculation will have to be decided.

Derivatives - when netted in the subsequent year

The trading and settlement system of derivatives, traded on the exchanges is divided into four cycles. These normally are January - March; April - June; July - September; October - December. An investor at any given point of time can transact in any of the cycles in progress or of any future date. For eg, an investor can take a position in month of February for the cycle ending in September. In such a case, for the accounts purpose, the deposit paid to the writer of the transaction and the margin position till date would appear either as an asset or liability depending on the profit or loss made in the transaction till the accounting year has ended. But at the end of the accounting year,the transaction is yet to be settled. hence, whether the amount of profit/loss made till the end of the year would be brought to tax on accrual basis or it would be brought to tax in the subsequent year when the transaction is finally settled? Similar issues would arise in the case of the writer (broker) of the transaction.

Recommendation

The above issues are not the only issues in this area, there could be many more and unless, the accounting as well as the tax provisions are clear on these, it may lead to innocent investors facing tax problems. It would also have to be mentioned that most of the entities treat derivatives as off balance sheet items and in those circumstances, proper accounting policies will also have to be prescribed for transactions in derivatives. Needless to say, that in the interest of the investors, it would be worthwhile for the ministry of finance to coordinate between the CBDT and Sebi and settle these issues, otherwise the investors who would jump into the bandwagon ofderivatives to reap the harvest would ultimately find themselves the losers, due to the tax implications of such transactions.

The author is a joint commissioner of income-tax, Ahmedabad, and the views expressed are his own