BY TAPAS JOSEPH AND ADITYA S. NAIR, FOURTH-YEAR STUDENTS AT NUALS, KOCHI
Introduction
Up until the early 2000s, derivatives revolutionized spot and futures markets, disrupting natural market relationships and attracting regulatory scrutiny due to potential negative effects. This increased leverage made futures leading indicators. Derivative markets, employing futures and options, became pivotal for trading stock risks, with legally binding contracts specifying asset transactions. Future contracts involves buyer and seller being legally bound to the purchase and sale of a specific asset at a specific price by a certain time. On the other hand, options contracts involve the buyer being given a right but not a responsibility to buy or sell a specific asset at a specified price before a given time, where the seller is also bound to fulfil the buyer’s right if they choose to exercise it. The income derived out of futures and options (‘F&O’) trading has always been classified in the realm of non-speculative business income for levying tax. However, due to recent increase in the retail participant trade activity, there is a plan to move the F&O income to speculative business income under the Income Tax Act, 1961 (‘Income Tax Act’). This reclassification would put F&O transactions under deterrent tax laws and tax deducted at source (‘TDS’) which will harm the traders to one extent or the other by implementing a niggardly tax system.
The Indian government’s proposed reclassification of F&O trading reflects growing concerns over unprecedented retail investor participation in derivatives. This regulatory shift aims to address potential systemic risks from unchecked retail F&O trading. Regulators worry that a major market correction could cause significant losses for retail investors, leading to widespread financial distress at the household level. This could have profound implications for market sentiment and economic stability. To mitigate these risks and ensure long-term market health, the government is considering reclassifying F&O trading income as speculative.
What is Speculative Transaction?
A speculative transaction is a transaction of purchase or sale of a commodity, being stocks and shares, and includes (section 43(5) of the Income Tax Act) a transaction that is not completed by the actual delivery of or by the transfer of the commodity.
Section 43(5) defines ‘Speculative Transaction’ as a transaction in which a contract for the purchase or sale of any commodity, including stocks and shares, is periodically or ultimately settled otherwise than by the actual delivery or transfer of the commodity or scripts. For example, intra-day trading in shares could be one such kind of trade that comes under the head of speculative transaction.
Understanding F&O Contracts in Financial Markets
F&O are types of financial derivatives that enable traders to speculate on the price movements of an underlying asset without owning it. A futures contract binds the buyer to purchase and the seller to deliver the asset at a set price and future date. Conversely, an options contract grants the buyer the right, but not the obligation, to buy or sell the asset at a specified price by a certain date, while the seller is required to fulfil the contract if the buyer opts to exercise their right.
Fiscal Implications for F&O Transactions
An eligible transaction in respect of trading in derivatives referred to in Clause (ac) of section 2 of the Securities Contracts (Regulation) Act 1956 carried out in a recognized stock exchange is not a speculative transaction.
Related to this, the Income Tax Act under section 43 (5) classifies F&O transactions as business income. This condition provides an exemption for trading in derivatives under clause (d). The section also includes subsection 5, which has clauses (a) to (e), and it specifically excludes speculative transactions. These include:
- Hedging contract with respect to raw materials or merchandise.
- Hedging contract with respect to stocks and shares.
- Forward contract.
- Trading in derivatives.
- Trading in commodity derivatives.
This makes trading under derivatives like F&O fall under the ambit of non-speculative business income, which is taxed under tax slabs based on the trader’s annual turnover.
In essence, the profits from F&O trading are taxed like other business income, allowing taxpayers to claim deductions for expenses incurred, such as telephone bills, electricity bills, internet bills, etc.
Prior to the addition of Clause (d) to the proviso of sub-section 5 of section 43, the Bombay High Court in Commissioner of Income Tax v. Bharat R. Ruia, determined that exchange-traded derivative transactions carried out by the assessee before January 24, 2006, were deemed speculative transactions. With the insertion of Clause (d) in section 43(5), an explanation was also introduced to define the term ‘Eligible Transaction’ as used in Clause (d). According to this explanation, only specific types of derivative trading transactions conducted on recognized stock exchanges are classified as non-speculative transactions. This was formalized by Notification No. S.O. 89(e) dated January 25, 2006. In this regard, from the date of Securities and Exchange Board of India (‘SEBI’), both Bombay Stock Exchange (‘BSE’) and National Stock Exchange (‘NSE’) were officially accorded recognition only for this particular purpose. Therefore, any derivative trades that were carried out in those exchanges and any others that may be entered in the future under the provision of this section are, in effect, non-speculative if they meet the conditions in the explanation of section 43 (5). These classifications apply to each of the transactions that satisfy the above conditions after January 25, 2006. The fact that for eligible derivative trades, there is a change of status from speculative to non-speculative is a major overhaul in tax and regulation.
Analytical Assessment of Derivatives Taxation Reclassification: Implications for Market Participants
F&O trading is considered a non-speculative business, and loss from its trading is allowed to be set against income from any other resource except salary income. This has been vividly described under section 71(2A) of the Income Tax Act.
Unadjusted losses can be offset against income from other sources, except salary. Any remaining loss can be carried forward for up to eight years. In these subsequent years, the carried forward loss can only be offset against income under “Profit and Gains of Business and Profession.”
Under section 73A, if a taxpayer incurs a loss from a speculative business transaction, they can only set off this loss against profits earned from other speculative business transactions. This means that a taxpayer cannot use a speculative business loss to offset gains earned from non-speculative business transactions, such as income from salaries, rent, or interest.
In case a taxpayer is unable to set off the entire speculative business loss against profits earned from other speculative business transactions in the same financial year, they can carry forward the unabsorbed loss to the subsequent year. The unabsorbed loss from speculative business can only offset profits from similar transactions and be carried forward for four assessment years, as per section 73. This differs from non-speculative business losses, which can be carried forward for eight years.
Examination of the Potential Impact on Market Behaviour and Investor Sentiment.
The imposition of increased taxes on F&O trading could potentially reduce liquidity and trading volumes in these markets by dissuading active traders. While there are numerous drawbacks associated with such changes, they may also serve to influence market participants. For instance, the growing presence of retail investors in derivatives markets raises concerns about their vulnerability to significant losses during market corrections. Reclassifying F&O transactions as speculative could function as a deterrent, aiming to mitigate these risks and dissuade retail investors from exposure to substantial losses.
However, there is also a risk that heightened taxes could redirect retail investors towards unregulated and potentially riskier investment alternatives. While these alternative channels offer the potential for greater profits, they operate outside the regulatory framework of traditional markets. This lack of oversight may expose retail investors to increased risks, potentially compromising their financial security. Institutional investors, who constitute a substantial segment of the F&O market, may reassess their strategies in response to these developments. The increased tax burden might influence their assessments of risk versus reward, altering market dynamics and potentially increasing volatility. Moreover, smaller market participants could face heightened operational costs and complexities as a result of these changes.
Conclusion and a Way Forward
The proposed reclassification of F&O transactions from ‘business income’ to ‘speculative income’ in India aims to protect retail investors but risks driving them to unregulated alternatives. To balance investor protection with market vitality, we propose:
1) A tiered tax structure with lower rates for small investors and higher rates for large traders, curbing speculation while maintaining liquidity;
2) Partial reclassification to a hybrid category, retaining some non-speculative tax benefits while introducing restrictions;
3) Extending the loss carry-forward period beyond four years for speculative transactions. These amendments could foster a stable yet dynamic F&O market, ensuring fairness without unduly burdening traders. A robust regulatory framework remains crucial for maintaining transparency and investor confidence.
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