The taxation of derivatives is probably just as complicated as trading derivatives itself. Derivatives transactions raise several challenges, as understanding their taxation requires thorough legal analysis. Concerns arise about income characterisation, derivative treatment, and underlying transactions. In this article, we will discuss derivatives and how they are taxed in India.
Understanding derivatives
A ‘derivative’ is an instrument whose value is based on the underlying cash or physical asset. This indicates that the value is derived from foreign exchange, currencies, securities, and commodities. The primary purpose of derivatives risk management and profit generation by predicting the underlying asset’s value in the future, with risk mitigation often described as volatility management tools.
Types of derivatives
You can trade four different forms of derivatives in the Indian Stock Market. Each derivative is unique and has different contract terms, levels of risk, and other factors. They are:
- Forward: A contract that allows two parties to acquire or sell an asset at a defined price on a future date.
- Future: A defined exchange-traded contract for the purchase or sale of an asset at a specified price on a specific future date.
- Options: A contract that grants the buyer the right (but not the obligation), to acquire or trade an item at a predetermined price before or after its expiration.
- Swap: A derivative contract in which two sides swap funds or financial commitments to mitigate interest rate or currency risk.
Now let us understand how each of these is taxed.
Taxation for derivatives
In India, derivatives are considered non-speculative business income and are taxed accordingly, rather than being classified as capital gains. This is in contrast to income from shares, which are taxed as capital gains in India. Let’s see how each of these derivatives is taxed in India.
Forwards and Futures
Both these derivatives follow the same tax laws.
- If they are traded on a recognised stock exchange and the Securities Transaction Tax (STT) is paid, both are considered sources of non-speculative business revenue.
- Profits are included as income from business and added to your overall income and taxed according to your income tax slab rate.
- You can carry losses forward for eight years and offset them against additional sources of business income, except for salaries.
Options
- Even in Options, premium profits and losses are considered non-speculative business income (as long as they are traded on recognised exchanges).
- The earnings from options are included in your total income and taxed according to your income tax slab rate.
- Expenses such as broking and transaction fees can be deducted from these earnings.
Swaps
In India, these contracts are not traded on an exchange. The type of tax depends on the nature:
- Gains or losses are considered company revenue if used for hedging.
- Classified as speculative income (with stricter limitations on loss set off) if utilised for speculative purposes.
Things to remember when filing taxes for derivative income
- Turnover is defined as the sum of all profit and loss, not by the deal’s value.
- Trading in F&O is deemed a non-speculative business income; therefore, you need to file under ITR-3.
- You can carry over losses from F&O for up to eight years, but this is only possible if you submit your return by the deadline.
- Maintain electronic records and contract notes for every single trade.
- If your income is large, you should make advance tax payments.
- A tax audit is required if your turnover reaches one crore (or 10 crores with 95% or more of your transactions being digital) or your profits fall below the level under Section 44AD.
- You can deduct expenditures that include, but are not limited to, fees for broking services, costs associated with software or advisory services, charges for internet service or dematerialisation, and depreciation (if applicable).
- You can offset F&O losses against your business income, capital gains, and other sources of income that are not a salary
In India, derivatives are taxed as business income rather than capital gains, bringing them under regular income tax bracket rates. You need to make a clear distinction between speculative and non-speculative transactions to avoid confusion and do rigorous record-keeping and stay compliant.
Given the intricacies of tax rules and the frequency with which authorities alter them, it makes sense to contact a tax specialist to assist you in your taxation. This will ensure you are compliant and effectively plan for tax liabilities.
