Individual investors have started investing in the derivative market due to the multiple exciting opportunities that the sector offers. However, the taxability of such instruments is still not very clear.
Individual investors have started investing in the derivative market in India due to the multiple exciting opportunities that the sector offers to make profit. However, the taxability of such derivative instruments is still not very clear. We have tried to provide answers to some basic questions on the issue.
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.”
In simple words, the derivative itself is a contract between two or more parties, and its price is directly related to the fluctuations of price of the underlying asset. The sale of such security is periodically or ultimately settled otherwise than by actual delivery or transfer of commodity or scrips. The most common types of derivatives in India are futures and options.
While the income earned by individuals from derivative transactions is taxable in India, whether it would qualify as ‘capital gains’ or as ‘profits and gains of business or profession’ depends on the circumstances of each case.
Based on various judicial decisions, one has to take into consideration the following parameters to determine whether the income from derivatives transactions is to be considered as capital gains or profits and gains of business or profession:
1. Whether the intention is only trading in securities or the intention is to create wealth and investment?
2. What is the volume of transactions?
3. What is the frequency and multiplicity of transactions of purchase and sale?
Derivative income classified as ‘Profits and Gains of Business or Profession’
a. Type of Business income
If income from derivative transactions is classified as business income, it can be further classified as income from speculative transaction or income from non-speculative transaction.
If the derivatives are traded on a recognized stock exchange in India, then income from such derivatives is treated as business income from non-speculative transactions. However, if the derivatives are not traded on a recognized stock exchange in India, then the income is considered to be from speculative transactions.
b. Applicability of presumptive taxation scheme
# Presumptive taxation is applicable:
If the turnover from derivative transactions is less than or equal to Rs 2 crore, then the income from these transactions can be taxed under the presumptive taxation scheme. As per the presumptive taxation scheme u/s 44AD, since the transactions are undertaken with the use of electronic clearing system through a bank account, the amount of income from these transactions shall be deemed to be 6 per cent of the turnover or a higher amount declared by the taxpayer. If the transactions are undertaken without the use of electronic clearing system, the amount of income from these transactions shall be deemed to be 8 per cent of the turnover or a higher amount declared by the tax payer.
As per the FAQs released by the Income Tax Department, books of accounts are not required to be maintained, if income is offered to tax under presumptive taxation scheme and the provisions related to audit of accounts u/s 44AB (tax audit) are not applicable in such cases where total turnover does not exceed Rs 2 crore and profits deemed to be taxable at 6 per cent/8per cent or more, of turnover.
# Presumptive taxation is not applicable:
When turnover is more than Rs 2 crore or when the turnover is less than or equal to Rs 2 crore but the income is declared to be less than 6 per cent/8 per cent or there is a loss to be declared, presumptive taxation is not applicable. The income will be taxable at normal rates of taxation. The taxpayer will be required to maintain books of accounts and get them audited u/s 44AB.
c. Turnover for derivatives
As per the guidance note on tax audit, the turnover is determined as summation of absolute values of profits and losses.
For example, 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).
d. Type of ITR Form for AY 18-19
# ITR 4 if income is declared as taxable under presumptive taxation i.e. u/s 44AD
# ITR 3 if income is declared taxable as normal business income (i.e. not under presumptive taxation)
e. Reporting of losses in the ITR Form
# Speculative business income
Loss from speculative business transactions can be set off only against profit from speculative business transactions. If the losses are not set off against profit from speculative business transactions, in any given financial year, then such loss can be carried forward and set off against profit from speculative business income for the next 4 years.
# Non-speculative business income
Losses from non-speculative business transactions can be set off against income from any other source (except salary).
If the loss is not set off against any other income like house property, capital gains, or income from other sources, in any given financial year, then such loss can be carried forward and set off against business income for the next 8 years.
Derivative income classified as Capital Gains
a. Type of capital gains from derivative
If the derivatives are listed on a recognized stock exchange in India, the income from derivative transactions will be classified as income from Short Term Capital Gains (STCG) if they are held for not more than 12 months. If they are held for more than 12 months, then they are classified as income from Long Term Capital Gains (LTCG).
If the derivatives are not listed on a recognized stock exchange in India, the income from derivative transactions will be classified as income from STCG, if they are held for not more than 36 months. If held for more than 36 months, then they are classified as income from LTCG.
b. What is the tax rate applicable?
The rate of tax for income from derivatives is given below:
c. Which ITR Form is to be used?
Form ITR 2, only if the individual does not have profits and gains of business or profession.
d. How are losses reported in the ITR Form?
In the current year, if there is Short Term Capital Loss (STCL), the same can be set off against LTCG and STCG. However, if there is Long Term Capital Loss (LTCL), then the same can be set off only against LTCG. Any unabsorbed STCL/LTCL cannot be set-off against any other income earned under any other heads of income.
Such unabsorbed STCL can be carried forward and set off against income earned from ‘any capital gains” for the next 8 years and LTCL can be carried forward and set off only against LTCG for the next 8 years.
(By Homi Mistry, Partner, Deloitte India, and Mousami Nagarsenkar, Director, Deloitte Haskins & Sells LLP)