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.
