Applying the Rules of Ind AS 109 "Financial Instruments" it makes sense to me as to why could income from Derivatives trading be taxed as Business income?
First and foremost, the standard lays down three basic conditions for an instrument to satisfy as Derivative instrument
- The Value of the contract will fluctuate based on the performance of the underlying asset.
- There will be a minimum or nil initial investment.
- The contract will be settled at a future date.
Analysis of Derivatives as Financial Liability (Unfavorable situation)
A financial liability will be classified as either of two :
- Amortised Cost - Since, there is no fixed rate of return for a derivative instrument (Fluctuating based on Underlying asset) it is not possible to identify the rate for calculation of effective rate of interest. Hence, Amortised cost method of accouting is not suitable.
- FVTPL - Fair value changes as on the date of disposal / Balance sheet, shall be routed through Statement of Profit and Loss. A derivative instrument as a Financial Liability would fall under this category.
- FVTOCI - A financial liability can never be classified as FVTOCI, as the same is related to equity.
Analysis of Derivatives as Financial Asset (Favorable Situation)
A financial asset has to satisfy a test called "SPPI Test" before it will classified as FVTPL, FVTOCI or Amortised cost. SPPI refers to the Solely Payment of Principle and Interest. It refers to any Financial Instrument that is issued solely for the purpose of payment of Principle and Interest, For example - A plain Debt Instrument. Derivative Instrument does not satisfy SPPI test as it is not issued or held for the purpose of payment of Principle and Interest.
Further, Classification of Financial Assets are based on the business model / Objective behind holding such instruments, and they are:
- Contractual Cash Flows till the maturity of Financial Instrument - Under this Model, a financial asset is held to its maturity to earn cash flows both in the form of interest and principle, this model also satisfies SPPI test. A financial asset will be classified as Amortised Cost under this model. Derivatives Instrument cannot be classified as Amortised Cost, as it is not possible to calculate the effective rate of return and also the instrument does not satify SPPI test.
- Contractual Cash flows along with Gain/Loss on Disposal of Financial Instrument - Under this Model, a financial asset is held to earn cash flows and can also be disposed before its maturity and realise gain/loss on such disposal. A financial asset under this model will be classified as FVTOCI and also this business model satisfies SPPI test. Even though the trading of Derivatives Instrument satisfies the business model / obejctives, but because of requirement of SPPI test, Derivative Instruments cannot be classified as FVTOCI.
- Other Various business models/ Obejctives - Under this model, the financial instruments can be held for various combinations/ objectives and there is no requirement for satisfaction of SPPI test. A financial asset under this model will be classified as FVTPL. Derivative Instruments will be classified under this model, as FVTPL as there is no requirement of SPPI test.
Under both the situations, i.e, Financial Asset and Financial Liability, a derivative instrument will always be classified as FVTPL, i.e, Fair Value changes transfered through Profit and Loss account. Since, trading of Derivatives are routed through profit and loss account, the same affects the profitability of the entity and will be generally taxed as Business Income.
This explanation may not be the actual fact, but understanding derivative instrument as per Ind AS 109 makes more sense as to why trading of derivatives could be taxed as business income and not speculation income.
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