1. TAXATION OF DERIVATIVES By Syed Muhammad Ijaz, FCA, LL.BUnder the Income Tax Ordinance, 2001 and the rules made there under no specific provisions are given dealing with the taxation of derivatives or derivative instruments. Taxation of derivates is quite a neglected subject in Pakistan. So far as accounting is concerned IAS 39 (Financial Instruments: Recognition and Measurement) deals with the measurement and recognition of derivatives whereas IAS 32 deals with presentation.IAS 391 defines derivatives in para 9 as;A Derivative is a financial instrument: Whose value changes in response to the change in an underlying variable such as an interest rate, commodity or security price, or index; That requires no initial investment, or one that is smaller than would be required for a contract with similar response to changes in market factors; and That is settled at a future date.Examples of Derivatives2;Forwards3: Contracts to purchase or sell a specific quantity of a financial instrument, a commodity, or a foreign currency at a specified price determined at the outset, with delivery or settlement at a specified future date. Settlement is at maturity by actual delivery of the item specified in the contract, or by a net cash settlement.Interest Rate Swaps and Forward Rate Agreements4: Contracts to exchange cash flows as of a specified date or a series of specified dates based on a notional amount and fixed and floating rates.Futures5: Contracts similar to forwards but with the following differences: futures are generic exchange-traded, whereas forwards are individually tailored. Futures are generally settled through an offsetting (reversing) trade, whereas forwards are generally settled by delivery of the underlying item or cash settlement.Options6: Contracts that give the purchaser the right, but not the obligation, to buy (call option) or sell (put option) a specified quantity of a particular financial1 IAS 39 Financial Instruments: Measurement and Recognition 2 http://www.iasplus.com/standard/ias39.htm 3 ibid 4 ibid 5 ibid 6 http://www.iasplus.com/standard/ias39.htm

2. instrument, commodity, or foreign currency, at a specified price (strike price), during or at a specified period of time. These can be individually written or exchange-traded. The purchaser of the option pays the seller (writer) of the option a fee (premium) to compensate the seller for the risk of payments under the option.Caps and Floors7: These are contracts sometimes referred to as interest rate options. An interest rate cap will compensate the purchaser of the cap if interest rates rise above a predetermined rate (strike rate) while an interest rate floor will compensate the purchaser if rates fall below a predetermined rate.Contracts with Embedded Derivatives8: Some contracts that themselves are not financial instruments may nonetheless have financial instruments embedded in them. For example, a contract to purchase a commodity at a fixed price for delivery at a future date has embedded in it a derivative that is indexed to the price of the commodity.An embedded derivative is a feature within a contract, such that the cash flows associated with that feature behave in a similar fashion to a stand-alone derivative. In the same way that derivatives must be accounted for at fair value on the balance sheet with changes recognized in the income statement, so must some embedded derivatives. IAS 39 requires that an embedded derivative be separated from its host contract and accounted for as a derivative when: [IAS 39.11] the economic risks and characteristics of the embedded derivative are notclosely related to those of the host contract a separate instrument with the same terms as the embedded derivativewould meet the definition of a derivative, and the entire instrument is not measured at fair value with changes in fairvalue recognized in the income statementIf an embedded derivative is separated, the host contract is accounted for under the appropriate standard (for instance, under IAS 39 if the host is a financial instrument). Appendix A to IAS 39 provides examples of embedded derivatives that are closely related to their hosts, and of those that are not.Examples of embedded derivatives that are not closely related to their hosts (and therefore must be separately accounted for) include: the equity conversion option in debt convertible to ordinary shares (fromthe perspective of the holder only) [IAS 39.AG30(f)] commodity indexed interest or principal payments in host debtcontracts[IAS 39.AG30(e)] 7 ibid 8 ibid 3. cap and floor options in host debt contracts that are in-the-money whenthe instrument was issued [IAS 39.AG33(b)] leveraged inflation adjustments to lease payments [IAS 39.AG33(f)] currency derivatives in purchase or sale contracts for non-financial itemswhere the foreign currency is not that of either counterparty to thecontract, is not the currency in which the related good or service isroutinely denominated in commercial transactions around the world, and isnot the currency that is commonly used in such contracts in the economicenvironment in which the transaction takes place. [IAS 39.AG33(d)]If IAS 39 requires that an embedded derivative be separated from its host contract, but the entity is unable to measure the embedded derivative separately, the entire combined contract must be designated as a financial asset as at fair value through profit or loss). [IAS 39.12]TAXATION OF DERIVATIVESAs stated earlier the Income Tax Ordinance and the Rules made there under have not dealt with the issue of derivatives specifically. Provisions dealing with the speculation business still can, to some extent, handle the taxation of derivates yet they are incapable to deal with complex transactions.Under Section 2(61) read with section 19 speculation business means any business in which a contract for the purchase and sale of any commodity (including 1[stocks] and shares) is periodically or ultimately settled otherwise than by the actual delivery or transfer of the commodity, but does not include a business in which (a) a contract in respect of raw materials or merchandise is entered into by a person in the course of a manufacturing or mercantile business to guard against loss through future price fluctuations for the purpose of fulfilling the persons other contracts for the actual delivery of the goods to be manufactured or merchandise to be sold;(b) a contract in respect of stocks and shares is entered into by a dealer or investor therein to guard against loss in the persons holding of stocks and shares through price fluctuations; or(c) a contract is entered into by a member of a forward market or stock exchange in the course of any transaction in the nature of jobbing 2[arbitrage] to guard against any loss which may arise in the ordinary course of the persons business as such member.Important Points 4. Section 71 defines any amount taken in account must be in rupeesconverted at the SBP rates prevailing on the date the amount was taken inaccounts. Income from speculation shall be treated as a distinct and separatebusiness Section 67 defines that expenses where attributable to various heads ofincome shall be apportioned Federal Board of revenue by using power u/s 237 has issued Income TaxRules 2002 wherein rule 13 is for apportionment of expenses. Under section 103 for tax credit even the speculation income has to betreated separately. Section 104 defines that incase of foreign lossessection 67 shall apply for apportionment of expenses.Speculation LossesSpeculation losses can only be setoff against speculation income and that only for 6 years max immediately succeeding the tax year in which the loss first arise.IAS 39 VS. SPECULATION BUSINESSForwards vs. section 19As per IAS the forwards are the settled through actual delivery or by payment through cash where section 19 applies to any type of commodities which are settled otherwise than actual delivery or transfer.Section 19 further excludes contract entered incase of goods manufactured or merchandizes from future price fluctuations.Interest Rate Swaps or Forward Rate Swaps vs. section 19Cash flows are exchanged as per IAS under these cases whereas u/s 19 cash flows cannot be categorized as commodity, stock or shares.Futures vs. section 19The only difference between forwards and futures is the settlement which in case of forwards is by way of actual delivery or cash payment where in case of futures it is by way of offsetting which duly falls within the ambit of section 19 being settlement without delivery. Again certain exclusions are given under the definition of speculation business in section 19. Options vs. section 19 5. Section 19 only covers commodities, stocks and shares which are not defined with reference to this section. Further section 19 does not cover the rights of buy and sell it covers as stated earlier only commodity, stocks and shares.Caps and Floors vs. section 19Just like an option, some times called interest rate options. As stated earlier options are outside the ambit of section 19EXCHANGE GAIN/(LOSS)Any realized exchange gain or loss as a result of foreign currency translation exposure is taxable being the part of the consideration. Notional gains are not taxable.CONCLUSIONWith the development of financial management complex tools/instruments are developed and it is an ongoing process. Derivatives are closely being watched by the taxation authorities of many countries like US. Proper rules and guidelines shall be issued by the FBR for taxation of such instruments clearly indicating; When such transactions are subject to tax When they will be treated as capital gain When their nature will fall within the business incomeUnless and until clear markings are made, there will remain great confusion regarding taxation of the derivatives.REFERENCESBooks IAS 39 IAS 32 Income Tax Ordinance 2001 Income Tax Rules, 2002Online Resources/URLs IASplus by Deloitte http://www.iasplus.com/standard/ias39.htm Fbr.gov.pk