Taxation of derivatives in shares.

Nilesh Shah Writes:
Cell: 92246-59941
E Mail: nilesh63@vsnl.com

Taxation of derivatives in shares .

Whether derivatives are `capital assets' within the meaning of sec 2
(14) of the Income Tax Act ? The term `capital assets' means property
of any kind held by an assessee, whether or not connected with his
business or profession, but excludes stock in trade of the business &
few other items specified in the said section. As noted, the
definition is wide & is held to include not only the property, but a
right to acquire such property. Derivatives are securities as defined
u/s 2(h) of Securities Contract (Regulation) Act, 1956, and
therefore, property with value. Derivatives accordingly are capital
assets, unless held as stock-in-trade of business. Futures & Options
are contracts representing a property of value capable of being
acquired, held & transferred, & have all the important ingredients of
Capital Assets. Both types of contracts create rights & obligations &
carry their own values.

Thus, derivatives can be taxed either under capital gains or as
profits of the business. A constant tug of war is on to determine
whether securities related income represents profits of the business
or are capital gains. In some cases the dividing line is so thin that
the issue can be better decided by a toss of a coin than by elaborate
reasoning .

Some of the factors considered relevant are the length of the holding
period, intention, regularity or the frequency, source of funds, the
administrative set up, use of sale proceeds, circumstances leading to
sale, accounting treatment, manner of acquisition, proportion of such
income & the overall time devoted for the activity.

Speculation business is defined in sec 43(5). Clause (d) of the
proviso to section 43(5) provides an exception for certain eligible
transactions of derivatives w.e.f. assessment year 06-07. Such
exclusion of derivatives transactions is however, subject to certain
conditions. These conditions, in short, are:

the transaction should have been carried out electronically on a
screen based system;

the transaction should have been carried out through a share broker
or a sub-broker;

the transaction should have been carried out on a recognised stock
exchange i.e either BSE or NSE ;

the bill should have the PAN etc;

the client should possess a time stamped contract.

Can derivatives be treated as non-speculative even when entered into
prior to A.Y 06-07. Since the exclusion from speculative is subject
to many conditions, the amendment cannot be considered as
clarificatory & therefore retrospective. It can only be held to be
prospective.

Derivatives, though securities, are financial contracts without any
physical existence.
I
have been given to understand that from beginning till today equity
stock options &
equity stock futures cannot be settled by delivery, but can only be
cash settled. A
transaction backed by actual delivery is not treated as a speculative
transaction. The condition presupposes that it is actually possible
to deliver the product. The law can prescribe only such conditions
which are capable of being fulfilled & complied with. It cannot
compel a person to do a thing which it legally cannot perform. Such a
condition if provided will be redundant. This is supported by the
principle `Lex non cogit ad impossibilia'. Thus, even without clause
(d) of the proviso to section 43(5), a derivative transactions could
not have been regarded as a speculative transaction.

The above view of mine is valid only because I have been made to
understand that the ultimate settlement is always in cash & not by
securities.

I don't have the knowledge of commodity trading & therefore, I will
refrain myself on commenting on the issue of taxation in commodities
exchange.

Your's Sincerely,

Nilesh Shah