Thanks for this useful post @Jason_Castelino
if someone were to implement this strategy this March and NOT carry forward to next FY, then the ITM PUT method seems more logical. Reasons: we have Monday, 31st March as market holiday and stock may reach the account on the next day (if ITM call were used). ITM PUT will have stocks taken away at EOD Thursday or Friday at most - keeping it within the FY.
I was trying to find how the physically settled derivatives are taxed as per the IT Act, i.e., whether they are to be fully treated as business income or fully treated as capital gains or as mentioned in this post, partly as business income and partly as capital gains.
I couldn’t find any provisions, at least nothing specifically on the topic of taxation of physical settlement of derivatives, in the Income Tax Act or from CBDT.
And when there is no clarity, it leaves the law open to interpretations.
But, I did come across this decade-old article by Mint, that kind of aligned with my thoughts, as i believe such physical settlements should either be wholly treated as capital gains or business income but not both at the same time.
Sharing the content of the above article for anyone not able to fully access it.
There has been no specific amendment in the tax laws nor has any circular been issued by the Central Board of Direct Taxes (CBDT) to clarify the tax treatment of such physical settlement of derivatives. One, therefore, needs to understand the position in the light of the existing laws.
The issues are whether the futures and the physical transaction are two separate transactions, or whether they are part of one continuous transaction, whether there is a transfer when the derivative gets extinguished and delivery of a share is taken or given, with any gain or loss on the derivative to be recognized at that stage, and what is the cost of the share acquired pursuant to physical settlement of the derivative transaction
To illustrate, take a case where you buy a futures contract in a company for Rs630, expiring in the last week of May 2011. Assume that the cash price of the company’s shares is Rs600 on the date of expiry and you take the delivery on that date. The questions that arise then are: Is the cost of your shares Rs630, or is there a loss of Rs30 on your futures transaction when your futures expire with the cost of the shares being Rs600?
It is only if the futures transaction and the acquisition of the shares are two separate transactions that one would need to compute the profit or loss on the futures separately, and treat the market value of the shares on the date of physical settlement as the cost of the shares. If the transactions of purchase of the futures and physical settlement are regarded as one single transaction, then the question of computing any profit or loss on the futures does not arise.
If one looks at the nature of the transactions, what is happening is that you are agreeing to buy shares at a future date with the price fixed now. That is the very nature of a futures transaction. Though a futures contract is a security which is separate and distinct from the underlying share, such distinction is only so long as the option of physical settlement is not exercised. The futures is a right to acquire the share. When physical settlement takes place, what is happening is that the right, which already existed, is being exercised. Such right merges into the share that is acquired. It cannot be said that you have given up the right and acquired a share instead.
For easier understanding, take a case where you book a motor car, by paying an advance of Rs50,000. When you actually take delivery of the car, you are purchasing the car. Till such time as you do not take delivery, what you have is merely the right to purchase the car. Can you say that you have exchanged your right to purchase the car for the car? Certainly not. All you have done is exercised your right to acquire the car. There is no profit or loss arising at that stage. The advance that you paid for the right also forms part of the cost of the car.
Therefore, in the example mentioned earlier in the column, no profit or loss on the futures transaction would need to be computed, but the cost of the share would be Rs630. If one had sold futures, the sale price of the futures would be the sale price of the shares delivered on physical settlement. Similarly, the premium paid on purchase of call or put options would have to be added to the purchase price or reduced from the sale price of the shares, where the options are physically settled.
Such tax treatment would also be consistent with the tax treatment of derivatives in other countries, such as the US or the UK. Given the tendency of income-tax officers in India to take extreme stands, one wishes that the CBDT would issue a circular clarifying such tax treatment, so that taxpayers are not put to unnecessary litigation.
Also I came across this other post with a similar view:
Uncertainty-surrounds-taxation-of-physically-settled-derivatives (1).pdf (93.3 KB)
Quite a few issues do arise in respect of taxation with reference to such physical settlement.
Is the derivatives transaction and the subsequent physical delivery of underlying shares to be
regarded as one integrated transaction of purchase or sale of shares?What is the cost or sale
price of the shares—will it be the cost of the derivative plus the amount paid on physical delivery?What would be the date of acquisition or the date of sale of the shares—will it be the
date that the derivatives transaction was entered into or the date of physical settlement of the
derivatives transaction? Would the derivatives transaction be regarded as a business
transaction?
Although i don’t have a definitive opinion on this topic, and just expressing my views, I do kinda feel it would appropriate to treat the entire transaction taking place through the derivatives markets, as a business income.
If the intent is to invest, why would anyone go to the derivatives market to take physical delivery of shares, when they can do the same from the cash market.
You don’t enter FNO to invest or own a capital asset, rather you do so, to gain from the price difference between the spot and the strike price.
So, if the intent is anything other than to hold as an investment, shouldn’t it be treated as business income ?
Taking delivery of shares doesn’t make it a capital asset by default, when someone is going to the derivatives market (business intent) and takes physical delivery, it is pretty much a stock-in-trade, rather than a capital asset; unless we can prove otherwise.
Imagine someone holding 2 demat accounts, one for trading and another for investing.
When you take physical delivery in the demat account linked specifically for your trading activity, wouldn’t you treat the entire transaction as a business income ?
Either, the profit or loss from sale of shares should be shown as business income (i.e., stock-in-trade)
Business profit or loss = (Selling price - (exercise price of shares + premium paid)
Or
If it is to be treated as capital gains, then the cost of acquisition of the shares through physical delivery, should include the premium paid (i.e., COA = premium paid + exercise price).
Anyways, I’m just trying to be the devil’s advocate here, with the hope to understand this better.
Thanks @SG_13 for your detailed post. While i skimmed through some of the points, here are my 2 cents on a few:
If the intent is to invest, why would anyone go to the derivatives market to take physical delivery of shares, when they can do the same from the cash market.
a few people might want to get a bargain while acquiring the stock. Cash Secure Put is one such strategy.
You don’t enter FNO to invest or own a capital asset, rather you do so, to gain from the price difference between the spot and the strike price. >
valid point. But there is a large group of investors doing the ‘wheel strategy’ while holding good quality stocks.
do share your opinion.
check this article - Derivative Contract being Settled by Physical Delivery of Shares is treated as similar to Transaction in Equity Share by Actual Delivery: Bombay HC [Read Order] | Taxscan
This article just talks about how CBDT wants to charge a higher STT when the contracts are physically settled. (i.e., The rates of STT as applicable to such delivery based equity transactions shall also be applicable to such derivative transactions), so this my not be relevant to our discussion here.
The key point we are discussing here is about the tax treatment of physically settled shares through the derivatives market.
i.e., How they would be taxed for Income tax purposes, not for charging STT.
Maybe you see the phrase “transaction in equity share” and assume that such physically settled shares will be treated as a capital asset and therefore it will be taxed as capital gains.
NO! It doesn’t work like that.
Equity(shares) can be classified either as Stock-in-trade (business) or as Capital asset (investment)
And, It is the intent and purpose for which the shares are held that determines how they are to be classified and taxed for Income tax purposes.
i.e., When the intent is to not hold on to the shares as an investment, rather to make quick profit from the price fluctuations, it is stock-in-trade and therefore the transaction will wholly be treated as a business income, rather than as capital gains.
The Income Tax Department of India clearly states that any trading capital that represents a profit has to be considered as a business income. Capital gains will only be applied if investments are made with the intent of earning an income, such as dividends. This can be best seen from the point of view of an example:
Let us assume that an individual, X has earned Rs. 100,000 through share trading activity for the short run. This may have been earned through intraday trading or a futures and options contract. The income is taxable as it is based under the head of income from “business” or “profession”, and thereby aligns with the tax slab that is applicable to X. Now, if X had held shares belonging to him for a substantial period, in order to gain returns, then income through capital gains would have been applicable.
While the dispute over capital gains versus business income is still a major bone of contention, the CBTE had issue a circular a circular to this effect in early2016 which largely clarifies this position. There will be 3 broad rules that the CBDT (Central Board of Direct Taxes) laid out for ratifying this classification.
If the taxpayer opts to classify his equity holdings as stock-in-trade, then the income shall be treated as business income. In such cases the AO shall accept the choice of the taxpayer and there shall be no grounds for dispute.
In case of long-term holdings (more than 12 months), the taxpayer is entitled to opt to treat the same as capital gains and the AO shall not dispute the same. However, the taxpayer shall maintain consistency in this classification and once opted will not be changed in future years.
In all the other cases, basic premise for classification of capital gains versus business income will be predicated on the concept of “Significant trading activity”. If the stock portfolio is churned frequently, then the income shall be classified as business income. The dispute, therefore, boils down to the classification of STCG on equities.
This simply means that when the shares are physically settled and they are sold immediately or less than 12 months (short-term), they are to be treated as Business income, not capital gains, simply because there is no Intent to hold them, rather it is meant for trading.
If the intention is to hold the shares that are physically settled for a longer term, then you can classify them as capital gains, even then, I don’t understand if it is right to treat the premium paid as business loss, and only take the strike price as the cost of acquisition…
IMO, the premium paid is a cost that is incurred in acquiring these physically settled shares, if the intention is to invest in them. So in essence it should be part of the cost of acquisition of the shares (i.e., Strike price + premium paid)
I believe this is how it is done in the U.S.A, from what I have read earlier and i could be wrong here.
NOt that it has any relevance to Indian tax laws, but this could be considered a precedent.
@loke4300 i hope this answers your question of what happens when derivatives are used for investing, rather than for trading. I do strongly believe, derivatives are meant for hedging and trading, and not for investing, but yeah, that’s just my opinion.
What’s Significant Trading Activity (STA)
While the definition of Significant Trading Activity (STA) is still open to discretion, the CBDT has indicated some broad rules that will be used for this classification. The decision will boil down to whether the short-term equity holdings are to be classified as Investments or as Stock-in-Trade. Here are some such broad rules that are indicative of the same
The volume of equity trading during a particular period is taken as a proxy for this classification. While there are no hard and fast cut-offs, some online brokers do advise traders to classify as business income if the trading volumes in a particular fiscal year exceed Rs.1 crore.
The ratio of purchases to sale is also a criterion. If the purchases and sales of shares are of similar magnitude it is typical of a trader and must be classified as business income. A proclivity to buy and hold is more a sign of an investor.
The average period can be a good proxy for this classification. Normally if your average holding period is shorter then it is more likely to be business income rather than classified as capital gains.
Activity in the Futures and Options trading is also an indicator of whether the income from shares should be classified as capital gains or business income. A trader being more active in F&O is a sign of a shorter time frame and a greater intent to trade.
Here’s something from the Zerodha’s Varsity on Trading v/s Investing and their tax treatment
For equity delivery-based investments, if you are holding stocks for more than a year, you would have received some kind of dividend, and even if you didn’t, you can show them all as investments and claim an exemption under the long-term capital gain. If you are buying and selling stocks frequently (yes, it is an open statement, but there is no rule that quantifies ‘frequent’) for shorter terms, it is best to declare that as non-speculative business income instead of STCG.
Another thing to keep in mind is that if investing/trading in the markets is your only source of income, and even if your trading activity is moderate, it is best to classify income from all your equity trades as business income instead of capital gains. On the other hand, if you are salaried or have some other business as your primary source of business, it becomes easier to show your equity trades as capital gains, even if the frequency is slightly higher.
You can be a trader and investor both at the same time. So, you can have stocks meant as an investment for the long term, and stocks meant for shorter-term trades. Just because you indulge in a lot of shorter-term trades wouldn’t necessarily convert all your long-term holdings or investments into trades and, therefore, bring those long-term gains under business income. However, it is important to clearly demarcate your trading and investment portfolio while filing returns
Even though this might seem confusing, rules are made for 1% of the population that is trying to break them. As long as your intent is right, you know the basic concerns of the IT department and keep those in mind while filing IT returns. It is quite simple. But stay consistent with the way you classify yourself, and don’t keep switching between being an investor or trader to declare your short-term equity trades.
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Look, i could be wrong here, but all I’m trying to convey based on my limited understanding on this topic is, Physically settled shares through derivatives, which are held for short-term, should be classified as business income and not capital gains.
But this is just my view, please check out all possible resources on this topic and come to your own conclusion, that convinces you.
The key word in this whole discussion is INTENT.
The intent to hold as investment or Stock-in-trade
The intent to plan your tax or avoid it
As long as the intent is right, you can justify your decision, come what may and be at peace with it.
And my intent in this whole discussion is for people to make informed decisions, so I leave it to your interpretation.
Cheers! 
Sorry, I have no idea about options.