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.
SOURCE
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! 