Taxing Times For Derivatives

The derivative market in India has started developing in the past few months. But there is no specific provision in the Income-Tax Act dealing with the taxation of derivatives.

The main concerns in derivative taxation are:

* Hedge accounting: How to account for netting and carrying forward of income or loss in case of hedge transactions;

* Income or loss from activities: Whether income Ooss) from trading in derivatives will be treated as income from speculation or business income.

* Timing: When to book profit or losses on the transaction.

Realistically the tax treatment often tends to follow the accounting treatment in such matters.

 

Under section 28 of the I-T Act eight types of income are chargeable under the head "profits and gains of business or profession". The relevant types are "profits and gains of any business or profession" and income from speculative transaction.

The purpose of hedge accounting is to maintain consistency between gains and losses arising from the underlying assets, and those derived from their hedging (derivative) transactions. With this basic objective, the realisation of gains and losses from the derivative transactions is deferred until the gains or losses of the underlying assets are recognised.

Rules are also required to distinguish between micro-hedge and portfolio hedges. Micro-hedge means a hedge for a specified transaction. Portfolio hedge means a hedging programme to manage the risk of the entire portfolio of Undifferentiated underlying transactions.

Hedge accounting therefore has two elements. Firstly, proof of hedge. That is, evidence that the transaction is not speculative in nature, and that there is an underlying transaction which has been covered through the hedge.

According to section 43(5), speculative transactions means a transaction in which a contract for the purchase of sale of any commodity, including stocks and shares is periodically or ultimately settled, otherwise than by the actual delivery oil transfer of the commodity or scrips.

However, the I-T Act does recognise the liedge contracts entered into by merchants in the course of business to guard against future business losses.

Therefore, the assessee has to prove that the transaction is a hedge transaction and not a speculative transaction.

Thus, according to the present provisions of the I-T Act a derivative is a speculative contract unless it is otherwise proved to be a hedge: that is, a mechanism of risk management.

Since the IT Act says that if an assessee carries on a speculative transaction of such a nature as to constitute a business, such business should be deemed distinct and separate from any other business. In case of banks or stock brokers, the implications are profound: should derivative trading be seen as a separate business?

The exemption from speculative income is given to members of forward market and stock exchanges as it is their business to enter into such type of contracts. There was no concept of financial derivatives a decade back internationally and fill about a few months back in India. The RBI has since issued guidelines for interest rates swaps (IRS) and forward rate agreements (FRA). But for scheduled commercial banks, primary dealers and all-India financial institutions, IRS and FRA are products for their own balance sheet management and for market making purpose.

Clearly, there is a gap, which could prove costly for banks and the like. Market-making business by brokers or bankers in the derivatives of market-makers cannot be said to be speculative business. Perhaps banks' trading book should be treated in the same way as contracts entered into by a member of forward market or stock exchange. Hence to enable the tax department to allow such (derivative) income/loss as eligible profit from business or profession, an amendment may be necessary to change the definition of speculative income for market-makers.

Income for banks and dealers from trading in derivatives may not be termed as speculative income, but for- others, including corporates, it may continue to be such, unless specified conditions are satisfied.

Individuals are a separate category. It may be difficult for an individual to prove hedge accounting if he invests in futures because it is hardly possible that the individual will be having/have sold all the shares represented in the index and in the quantity of index. Therefore, his profits and losses will be taken as speculative profits or losses and such losses will not be allowed to set off against his other incomes. Index

future can be and are used for hedging of portfolio risk of a portfolio which may not contain index portfolio.

As to timing of booking profits or losses, section 145 of the I-T Act leaves the choice to the assessee, but the latter has to show that he has regularly followed that particular method.

The central government has already notified Accounting Standard I relating to accounting policies. Basically, it says the accounting policies adopted by an assessee should be such as to represent "a true and fair view of the

state of affairs of the business, profession or vocation in the financial

statements prepared and presented on the basis of such policies."

The major consideration governing the selection and application of accounting policies are:

* Prudence: Provisions should be made for all known liabilities and losses even though the amount cannot be determined with certainty and represents only a best estimate in the light of available information;

* Substance over form: The accounting treatment and presentation in financial statements of transactions and events should be governed by their substance and not merely by the legal form; and

* Materiality: Financial statements should disclose all material items, the knowledge of which might influence the decisions of the user of the financial statements.

Neither the Institute of Chartered Accountants of India nor the government has issued any guidelines on hedge accounting. In absence of any explicit

guidelines, within these principles if the transaction can be shown as hedging under the Drinciple of substance over form, it can be reasonably assumed that the tax officer would recognise the hedge Accounting.

As current laws stand, ail entity may enter into a derivative contract for trading or fledging purposes, only. If it enters into derivatives for trading purposes, it is a speculation activity. The I-T Act recognises contracts entered by dealers of stock or forward market to guard against loss in the normal course of their businesses and considers such activity as hedge and allows them to be treated as income from business.

But to bring the newly liberated banking sector in the fold, a further expansion of this provision is necessary as they too undertake market-making activity as part of their normal business activities.

With the expansion of the derivatives market, a lot of options are available to entities for risk management. But it may, some times, be difficult to show a one-to-one relationship between the derivative and the underlying transaction. The tax department may therefore have to either- issue guidelines for microand portfolio hedges or exempt trading in derivatives by all entities from the purview of speculative business. Mohan Bhatia can be contacted at bhatia100@hotmail.com

Neither, the Institute of Chartered Accountants of India nor the government has issued any guidelines on hedge accounting. In the absence of any explicit guidelines, if the transaction can be shown as hedghig under the principle of substance over form, it can be assumed that the tax officer would recognise the hedge accounting