Derivative Market & Taxation

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Derivative Market and Taxation

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Anubhav SharmaAvinash KumarAbhishekDebarun HazraManoj Bag

Tarun AgarwalSmit VasudevSahil Manchanda


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Introduction Derivatives are primarily risk management tools. More accurately, they are

volatility management tools.

Futures, options and OTC derivatives markets are integral parts of almostall economies of the world which have reached an advanced stage ofdevelopment.

The Indian government, based on the L.C. Gupta Committeerecommendations, has allowed trading in derivatives to begin in India.

The Derivatives Bill, passed recently, will give trading on the domesticbourses a new dimension, as

index-based trading would finally be permitted, a long-standing demand inthe Indian markets.

The shares underlying a stock exchange index would be traded as a singleunit.

The passing of the Derivatives Bill also requires a change in the definitionof securities in the Securities Contract (Regulation) Act (SCRA), toinclude the words 'futures' and 'options'.


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Its All Derivatives 'Derivative' is an instrument whose value depends on its

underlying cash or physical asset.

Hence it means that the value is derived from the value of theunderlying assets like foreign exchange, currency, securities and

commodities. It also includes market indices such as the LIBOR,BSE Sensex or benchmark interest rates

Derivatives include forward, future and option contracts that areof a pre-determined fixed duration.

Derivatives are used to hedge against price, currency and

interest rate risk. Since derivative instruments do not involverisks, they help redistribute the risk between market participants.

Hence, derivatives in this sense are used for risk management.Derivatives can also be used for speculative functions.


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Financial Derivatives According to the L. C. Gupta Committee formed in November

1996, the development of futures trading is an advancementover forward trading, and futures represent a more efficient wayof hedging risk.

A financial derivative is a financial instrument whose value islinked in some way to the value of another instrument, underlyingthe transaction. The value is derived from a basic financialinstrument.

The underlying assets could be securities, commodities,

currencies or indices. Financial derivatives provide for the purchase or sale of

traditional financial instruments in the future at prices that areagreed upon on the day of the contract.

Financial derivatives are used for hedging, speculation and

arbitrage.


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Forward Contracts Traders and investors who wish to hedge against their future

risks use the forward markets. This market is characterized byactual delivery of the underlying asset in most cases at the pre-determined date. Such contracts are used to hedge against pricefluctuations.

Example 1: 'A' agrees to purchase from 'B' 100 shares of 'C Ltd.'on a fixed future date for a pre-determined price of Rs. 100.Here, on the fixed future date, A will pay Rs. 100 to B and B willdeliver the shares of C Ltd. to A.

A B

Cash equivalent toFull Contract value

Shares


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Futures A future contract is a contract by which one party agrees to sell

to the other party on a specified future date, a specified asset ata price agreed at the time of the contract and payable on thematurity date. The agreed price is also known as 'strike price'.

Some types of financial futures contracts are:

Currency futures

Interest futures

Stock index futures

Example 2: 'A' enters into a future contract to purchase from 'B'

shares of C Ltd. at Rs. 100 on 31st December. If for instance, on31st December, the price of C Ltd. is Rs. 90, then A will pay to BRs. 10 per share. If the price of C Ltd. is Rs. 120 then B will payto A Rs. 20 per share.


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Cont The basic difference between forward and future contracts is that

in a forward contract, the entire principal flows from one party toanother i.e. exchange of assets take place. In the case of futurecontracts, on the other hand, only the net differential between thestrike price and the market price on the date of exercise isexchanged.

ABNet payments depending on

Gain or Loss


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Options An Option contract is a further variation of a forward or future

contract.

They are of two types, call options and put options.

A call option is the right, but not an obligation, to buy an asset in

the future at a pre-determined price. A put option is a right, but not an obligation, to sell an asset in

the future at a pre-determined price

Example 3: In example 2, if the price of C Ltd. on exercise date isRs 120, then A will exercise the option as he stands to benefit

from doing so. However, if the price falls to Rs. 90 then, he willnot exercise the option, thus restricting his loss to the amount ofthe premium paid by him.


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Cont

A BNet payments depending onGain or Loss (optional)

Premium


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Caps, Floors and Collars Caps, floors and collars are series of options.

In a cap, the strike price for an option is not fixed, only an upperlimit on the strike price is fixed. If on the maturity date, the marketprice is higher than the cap price then the cap price will be the

strike price otherwise the market price will be the strike price. A floor is similar to a cap, the only difference being that in case of

floors the lower limit for the strike price is fixed.

A collar is a combination of cap and floor. In this case, strikeprice will be within a range of prices. It can not be higher than

cap price and lower than floor price determined in a collarcontract.


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Swaps A swap is a contract whereby parties agree to exchange

obligations that each of them have under their respectiveunderlying contracts.

A plain vanilla currency swap involves the following steps:

1. Exchange of equivalent amounts in different currencies2. Exchange of interest payment during the tenure of the swap

3. Re-exchange of the principal sum at the pre-determined rate onthe maturity of the swap agreement.

Example 4: A has borrowed from B at LIBOR + 2%. A now

desires a fixed rate of interest at about 9%. C on the other handis another player in the market, who is willing to borrow at LIBOR+ 2% and lend at 9%. A and C can enter into a swap transactionwhereby A borrows from C at 9% and lends to C at LIBOR + 2%on a notional principal. The actual amounts of the principals are

never exchanged. Only the interest payments are exchanged onnet basis.


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Cont

C A

B

LIBOR+2%

9%

L

IBOR+2

%

PrimaryLiability


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Approaches to Taxation IFA has published a comparative study of taxation of derivatives

in about 29 countries. As per the study, there are three basicapproaches to taxation of derivatives :

(1) Decomposition principle - under which every derivative

transaction is analyzed into a number of cash flows, each ofwhich can be separately valued and taxed

(2) Separate Transaction principle - under which each derivativecontract is looked at in isolation to establish an overall return oninvestment

(3) Linked approach - under which the related transactions areclubbed together to analyze the overall profit of the entiretransaction.


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Quote

Derivatives are not inherently bad orgood. They are a bit like electricity,dangerous if mishandled, but bearing

the potential to do tremendousgood.

-Levitt,

(Chairman of the United States Securitiesand Exchange Commission)


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CASE STUDY In 1995, financial markets the world over were shocked when the

233 year-old Barings Investment Bank was left with a loss of $1.3 billion by Nicholas William Lesson, a man who hadestablished a great track record of being a savvy trader in thederivatives market.

Though he had permission for intra day trading activities, heexceeded his authority by taking huge overnight positions. Hetraded simultaneously in Tokyo stock exchange-Nikkei 225 andSingapore Stock Exchange along with Osaka Stock exchange,Japan. His strategy amounted to a bet that the Japanese stockmarket would neither fall not go up substantially.


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Cont The Japanese stock market started falling on the news of a

violent earthquake in Kobe, Japan. Barings took a selfdestructive step when it allowed Lesson to act both as front officetrader and back office settlements manager.

Lesson used this to his full advantage and opened an account88888 which he used to hide losses that he was making onderivative trading activities.

Thereafter, he scaled up his trading activities in futures andoptions, and by December 1994 had accumulated losses of $208million on that account. All through this, he always represented tothe top management that he had been making profits in tradingactivities. This was concealed by not divulging the details ofaccount 88888 to Barings in London, giving false reports,misrepresenting the profitability of trading activities and a numberof false trading transactions and accounting entries.


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Cont Lesson expected Tokyos NIKKEI stock index to rise

substantially at the beginning of 1995 and took huge positions,which he lost heavily on when the index did not rise. He bought20000 futures contract over a period of three months in a futileattempt to move the market. The result is well known. A singletrader could not direct the market as desired and consequentlythe market fell drastically. As a result, Barings registered colossallosses on Lessons positions. The Bank was unable to sustainthese losses and one trader collapsed one of the most oldest andprestigious banks in England.


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Issues There seems to be a general acceptance of the theory that the

taxation of derivative financial instruments (popularly known asDFIs) is not to be determined by reference to the tax treatment ofthe underlying instrument to which the derivative relates. Mostcountries seem to have adopted the second i.e. separatetransaction principle.

There are three key issues in taxation of a derivative transaction :

1) Characterization of income i.e. business income or interest

2) Determination of income i.e. timing and cash flow

3) Withholding tax implications


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Cont Unlike traditional debt and equity securities and foreign currency,

derivative financial instruments do not involve a return on initialinvestment.

In view of this peculiarity, the characterization of income is of

great significance in order to determine its taxability Whether the income arising from a derivative transaction can be

regarded as interest, has been dealt with in the 1994 Report ofthe OECD on "Taxation of New Financial Instruments".

In 1995, Paragraph 21.1 was added to the OECD Commentary

on Article 11 which made it abundantly clear that in the absenceof underlying debt, the payment for a financial instrument will notbe regarded as 'interest'. This was made subject to 'substanceoverform rule and 'abuse of rights' principle.


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Derivative and type of income In general, the income arising from a derivative transaction

should be regarded as 'ordinary income'.

If a derivative transaction is entered into in the ordinary courseof business, it should be considered as 'business income'

otherwise, it should be characterized as 'other income'. In a cross-border transaction where a tax treaty applies, under

both these situations, income arising from a derivativetransaction should not be taxable in the country of source unlessthere exists a Permanent Establishment.


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Point of Taxation The next issue arises as to when the income should be taxed.

There are several points at which the income from a derivativetransaction may arise.

Initially, there may be a premium paid. In many transactions,

there will be intermediate value dates on which interest ordividend becomes payable on the underlying securities.

Further, many contracts are 'marked to market" which meansthat their value is adjusted in view of the market value of theunderlying asset on a periodic basis.

Finally, at the maturity, there is an ultimate settlement of thedifference. When and how to tax these cash flows may to someextend depend upon the method of accounting adopted by thetax payer.


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Cont Since in most of the cross-border transactions, derivative income

may not be taxed in the absence of a PE, it is crucial that thereare no withholding taxes leviable on such income.

However, this will depend upon the domestic tax law provisions

in each country and the provisions of relevant tax treatiesapplicable to such companies.


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Taxation of Derivatives in India Derivative transactions are still in nascent stage in India and their

tax implications are still to be tested by the Indian revenueauthorities.

There are no precedents directly on the subject. Margins in a

swap transaction are extremely narrow. Therefore, the impositionof taxes by the country of the payer substantially alters theprofitability of a swap.

General provision under the Income tax Act:

Indian residents are subject to tax on their worldwide income,

non-residents on the other hand are taxed only on incomereceived by them in India, or income that accrues or arises tothem in India2. Further, under certain conditions, income can be"deemed to accrue or arise in India" and thereby be subject totax in India3. Generally, the entire tax payable by a nonresidentin respect of income earned in India is liable to be withheld atsource.

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Cont Section 9 of the I-T Act covers situations under which income

which can be deemed to accrue or arise in India".

Under Section 9(1)(i) of the I-T Act, all income accruing orarising, through or from any business connection/property/asset

or source of income in India, is deemed to accrue or arise inIndia.

Only such part of the income as is reasonably attributable to theoperations carried out in India can be deemed to accrue or arisein India.

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Cont the Indian tax laws do not specifically distinguish between "doing

business in India" and "doing business with India".

The term "business connection which is crucial to determinationof taxable business income in India, is not statutorily defined.

In general, it can be interpreted as a continuous relationshipbetween a business carried on by a non-resident entity, whichyields profits or gains and some activity (in India) whichcontributes directly or indirectly to the earning of these profits orgains.

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Cont Though there are no direct cases on the point, courts have

opined on the taxability of profits/losses arising to an assesseemerely due to the appreciation or depreciation in the value offoreign currency held by it.

The position adopted by courts has been that such profits/losseswould ordinarily be trading profit/losses if the foreign currency isheld by the assessee in revenue account or as a trading asset oras part of circulating capital.

If, on the other hand, the foreign currency is held by theassessee as a capital asset or as fixed capital, such profit or losswould be of capital nature.

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Cont

The Finance Act, 1999 has enlarged the scope of theword interest. Now, interest includes hedgingtransaction charges on account of currencyfluctuation.

This would mean that any payment made for hedgingagainst foreign currency rate fluctuations in respect offoreign currency debt obligation may be exempt fromtaxation in India

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Withholding Tax :

In general, withholding tax is levied on interest,dividend or royalty payments. Most countries haveregarded payments under derivative contracts asfalling outside 'interest' and 'dividend' articles as they

do not reflect the true return on capital. The same principle should apply to payments of

differences on futures contracts, swap fees andpremiums on options. Most of these payments fall

within 'business profits' or 'other income' articles andtherefore, are remitted gross, free of withholdingtaxes.

The taxation is determined in the country of

residence.

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Indian Scenerio Section 195(1) of the I-T Act entrusts the payer with the liability to

withhold tax on certain payments being made to a foreignrecipient.

An issue arises with respect to withholdings under section 195that whether the payer has to deduct tax on the gross amount ofpayments due to the non-resident, or on the income or profitelement received by the non-resident.

The Supreme Court has authoritatively settled this issue in thecase ofTransmission Corporation of AP Ltd. V. CIT11.

The Apex court has held that the scheme under section 195 ofthe ITA applies not only to the amounts that bear an element ofincome or profit, but also to gross sums, the whole of which maynot be income or profit of the recipient.

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Cont It is pertinent to note that in case of a banking company,

exemption from withholding taxes is available only if thepayments (not classified as interest on securities or dividend) arereceived by the branch operating in India, on its own account andare not received on behalf of the head office or any other branch

situated outside India.

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Tax Implications on Swaps : The issue involved is one of characterization of the settlement

amount.

The characterization of the amount could be either businessincome or interest income.

There is a strong case for the swap payment to constitutebusiness income in the hands of the non-resident recipient asagainst interest income or other income.

Under the I-T Act, the term "interest" is defined under section2(28A) to mean interest payable in any manner in respect of

moneys borrowed or debt incurred (including a deposit, claim orother similar right or obligation) and includes any service fee orother charge in respect of the moneys borrowed or debt incurredor in respect of any credit facility which has not been utilized.

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Cont In a swap transaction, there is no money borrowed or debt

incurred. The principal of a swap deal is the notional amount andthe adjustment takes place between the bank and thecounterparty in respect of the amounts payable by them.

Only the net amount changes hands. Therefore, such amountsshould qualify as trading income.

However, in a synthetic transaction, where the deal is structuredin a manner where there is a debt incurred and the payment ismade in respect of debt incurred, such payment could beregarded as 'interest'.

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Cont

In the Indian context, such a situation may be thepractical reality faced by the Indian corporate who areforced to enter into synthetic transactions.

The consequences may be different in a cross-bordertransaction, especially where the non-residentcounterparty is from a treaty jurisdiction.

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Cont

If these amounts were to be treated as interest, theymay attract a withholding tax in India at the rate of20% on the gross amount16.

This rate could be reduced further depending uponthe tax treaty provisions.

If a foreign company earns any business income thatis deemed to accrue or arise in India, it would beliable to be taxed at the current applicable rate of 48%

on its net business income.

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Summary The Income Tax Act, 1961 of India did not have any specific

provision regarding taxability of derivatives income.

The tax authorities are still undecided on this issue, and in theabsence of any provision, derivatives transaction are held at parwith transactions of speculative nature, particularly, the indexfutures/options which were essentially cash settled, are treatedthis way.

Therefore, the loss, if any, arising from derivatives transactions,was treated as a speculative loss and was eligible to be set offonly against speculative income up to a maximum period of eightyears.

It is suggested that derivatives instruments are essentially usedby investors to hedge risks, and therefore they should not beconsidered as speculative transactions.

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Cont

They should be taxed as short-term capitalgains or losses on securities. The problem oflack of clarity on taxation needs to be

addressed urgently.

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Conclusion The entire concept of taxation of derivatives is at

crossroads, the dilemma is that if the derivativestransactions are regarded as taxable under the headCapitalGains, there is no provision for deduction of such

provision, particularly as the gains would be computed andtaxable only on the date of transfer, i.e. the date ofsquaring up or expiry of the derivatives, and not on anyinterim date.

Further, in computing capital gains, only the cost of

acquisition, cost of improvement and expenses inconnection with the transfer are deductible. Such provisionwould therefore not be deductible if the derivativestransaction income is taxable as capital gains.

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Cont If the derivatives transactions are taxable as Income from

Other Sources, the real income theory would againrequire the deduction of such provision for loss indetermining the taxable income.

There could be two possible interpretations viz. derivativestransactions are pure business transactions and hence, theincome/loss thereon should be assessed as normalbusiness income / loss.

The other view is that derivatives are covered under thedefinition of speculative transaction under section 43(5) ofthe Act in absence of delivery of the underlying security orcommodity.

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Contd.. Under the Act, speculative profits/losses are allowed to be setoff

only against speculative losses/profits respectively.

The unabsorbed speculative losses are allowed to be carriedforward for 8 immediately succeeding assessment years.However, setoff of such carried forward speculative losses isallowed to be setoff only against speculation profits.

This conclusion is supported by the fact that derivatives havegrown at explosive rates, and at times trading in derivatives haseven surpassed trading in their underlying instruments. However,derivatives are more risky than other traditional financial productsbecause they are highly leveraged, more complex and lesstransparent. Being relatively newer instruments, there is ageneral lack of understanding of how they operate or how theyshould be managed

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