Income from Derivatives, Its Nature and Tax implication and set off of Different Derivatives Losses

WHAT IS SPECULATION BUSINESS [SEC 43(5)]

As per section 43(5) speculative transactions means a transaction in which a contract for the purchase or sale of any commodity, including stocks and shares, is periodically or ultimately settled otherwise than by the actual delivery or transfer of the commodity or scrip.

In other words if any contract is settled otherwise than by the actual delivery of the commodity or script then the profit or loss shall be treated as speculation business.

However there are some exceptions when the profit or loss not treated as speculation even though the contract settled otherwise than by the actual delivery of commodity or scrip, these are as follows:

1. Contract in respect of raw materials or merchandise entered into by a person in the course of his manufacturing or merchanting business to guard against loss through future price fluctuations in respect of his contracts for actual delivery of goods manufactured by him or merchandise sold by him; or
2. a contract in respect of stocks and shares entered into by a dealer or investor therein to guard against loss in his holdings of stocks and shares through price fluctuations; or
3. a contract entered into by a member of a forward market or a stock exchange in the course of any transaction in the nature of jobbing or arbitrage to guard against loss which may arise in the ordinary course of his business as such member; [or]
4. an eligible transaction in respect of trading in derivatives referred to in clause [(ac)] of section 2  of the Securities Contracts (Regulation) Act, 1956 (42 of 1956) carried out in a recognized stock exchange;]

Eligible transaction in respect of trading in derivatives means any transaction,

1. carried out electronically on screen-based systems through a stock broker or sub-broker or such other intermediary registered under section 12 of the Securities and Exchange Board of India Act, 1992 (15 of 1992) in accordance with the provisions of the Securities Contracts (Regulation) Act, 1956 (42 of 1956) or the Securities and Exchange Board of India Act, 1992 (15 of 1992) or the Depositories Act, 1996 (22 of 1996) and the rules, regulations or bye-laws made or directions issued under those Acts or by banks or mutual funds on a recognized stock exchange; and
2. which is supported by a time stamped contract note issued by such stock broker or sub-broker or such other intermediary to every client indicating in the contract note the unique client identity number allotted under any Act referred to in sub-clause (A) and permanent account number allotted under this Act;

Recognised Stock Exchange means,

a recognised stock exchange as referred to in clause (f) of section 2 of the Securities Contracts (Regulation) Act, 1956 (42 of 1956) and which fulfils such conditions as may be prescribed and notified by the Central Government for this purpose;]

*NSE, BSE and MCX stock Exchange Ltd. is notified stock exchange.

Profit or Loss from Trading in Derivatives (Stocks & Index) is treated as business profit or loss, not speculation even though there is no actual delivery.

As per proviso (d) of section 43(5) profit or loss from a derivative transaction is treated as business profit or loss if following conditions are satisfied:

a)    It is carried out in a recognized stock exchange (as per section 2(f) of securities contract regulation Act 1956) and;

b)    It is carried out electronically on screen-based systems through a stock broker or sub-broker or such other intermediary;

c)    It is supported by the time stamped contract note issued by a broker, sub-broker or other intermediary

d)    It is carried out in a notified stock exchange by the central government for this purpose (NSE & BSE is notified exchange)

Profit or loss from trading in currency future is business income/loss

Profit or loss from trading in currency future is treated as business profit or loss if it satisfies the conditions (a) to (d) as discussed above.

For the currency future NSE, BSE & MCX stock exchange ltd is the notified stock exchange.

Profit or loss from Commodity future is speculation profit/loss

Profit or loss from trading in commodity future is treated as speculation profit or loss because it is not covered in the exceptions of the section 43(5). Exceptions of section 43(5) covers only derivatives referred to in clause [(ac)] of section 2 of the Securities Contracts (Regulation) Act, 1956 (42 of 1956) while  commodity future is regulated by Forward Market Commission (FMC) under Forward Contracts (Regulation) Act, 1952.

However if commodity future is booked by a person, to guard against loss through future price fluctuations in respect of his contracts for actual delivery of goods manufactured by him or merchandise sold by him, then it will not treated as speculation.

Profit/Loss from Dealing in Shares (Intraday, contract settled without actual delivery of shares) is Speculation Profit/Loss

Profit or loss from dealing in shares where contract settled otherwise than the actual delivery (Intraday) is speculation profit/loss. However if it is for hedging the existing position then it is not the speculation.

Profit or loss from dealing in shares (actual delivery of shares)

Shares held as investment and not as trading activity:

If shares held as investment then the profit or Loss from the share dealing will be Capital Gain either Short Term or Long Term.

Shares held as stock in trade

 Profit or Loss from trading in shares is a business profit or loss. However there are some exceptions given in explanation to section 73, if a company trades in the shares of other company.

Explanation to section 73

If the following conditions are satisfied a company shall be deemed to carrying on a speculation business to the extent to which the business consists of the purchase and sale of such shares:

a)    Assessee is a Company.

b)    It is not a Company whose gross total income consists mainly of income which is chargeable under the heads Interest on securities, Income from house property, Capital gains and Income from other sources.

c)    It is not a Company whose principal business is the business of banking or the granting of loans and advances

d)    Where any part of the business of a Company consists of purchase and sale of shares of other companies

In other words we can say that if a company engaged in the business of trading in shares of other company even on the delivery based, it deemed to carrying the speculation business if not comes in the exceptions given in the explanation to section 73.

Turnover for the purpose of section 44AB in respect of Derivatives transaction

Income tax is silent on the issue but as per the guidance note issued by the Institute of Chartered Accounts of India on Tax Audit u/s 44AB turnover shall be the aggregate of the favourable and unfavourable differences.

For example if in one contract there is a profit or Rs. 100000/- and in the other contract there is a loss of Rs. 100000/- overall no profit no loss in the books of an assessee, but as per guidance note turnover for the purpose of section 44AB will be Rs. 200000/-(Aggregate of the favourable and unfavourable differences)

Set off loss against income of from other source

Inter Source Adjustment [Sec 70):

If net result of a source is loss, it can be set off against the profit from the other source in the same head subject to following exceptions:

a)    Loss from Speculation business can be set off only against the profit from speculation business.

b)    Long Term Capital Loss can be set off only against the Long Term Capital Gain

c)    Loss from the business of owning and maintaining the race horses can the set of only against the profit from the business of owning and maintaining the race horses.

d)     Any loss cannot be set off against the winning from lotteries, crossword puzzles etc.

Inter Head Adjustment [SEC 71)

If net result of a head is loss, it can be set off against the profit from the other head subject to following exceptions:

a)    Loss from Speculation business cannot set off against the income of any other Head.

b)    Capital Gain loss cannot set off against the income of any other Head.

c)    Loss from the business of owning and maintaining the race horsed cannot set of against the income of any other Head.

d)    Loss from any head cannot set off against the income of winning from lottery, crossword puzzles etc.

e)    Business loss cannot set off against salary income.

Set off and carry forward of speculation loss [sec 73)

A speculation loss can be set off only against speculation profit.

Table showing adjustment of losses intra source and inter head

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CA Sahib S Choudhary

B.Com,ACA,DISA(ICAI)