In most of the developed countries, futures and options transactions far exceed the direct sale and purchase transactions in the commodities market including equities.

Now gradually, India is also emerging as a vibrant market for derivatives. The turnover in the derivative segment has reached a record of Rs 5,848.10 crore (Rs 58.481 billion).

The derivatives segment was considered to be, albeit arguably, a panacea for the ills of the badla regime. Though ushered in with fanfare, vitally, related taxation issues remain mired in confusion.

This piece attempts to discuss the issues and dilemmas that investors face after having entered the arena. However, first we shall briefly examine the exact nature of these derivative products.

Futures

A futures contract is an agreement between a seller and a buyer that calls for the seller (called 'Short') to deliver to the buyer (called 'Long') a specified quantity and grade of an identified commodity, at a fixed time in the future and at an agreed price. The contract is binding on both the parties.

Options

A logical extrapolation of futures is options. An options contract is one giving the purchaser of the option (the holder) to buy (call option) or sell (put option) a commodity at an agreed price at a prefixed date in future.

For this, the purchaser pays a one-time, non-refundable fee (called the option premium) to the seller of the option (the writer). The option premium is not adjusted against the future payments.

When an option holder exercises the option, he either pays the agreed-upon price (the strike price) if it is a call option or receives payment in case of a put option. If the holder decides to waive his option, which he can, he only loses the option premium.

In contrast, the writer of the option is obligated to make or receive delivery, depending on whether he wrote a call or a put option.

In either case, the writer of the option has no authority or right to determine whether or at what point, will the option be exercised. The right rests only with the purchaser of the option.

In short, both futures and options offer an opportunity to an investor to participate in the market without having to invest huge amount of capital.

Both the investors and speculators can use futures and options for their ventures. If an investor believes that the price of a particular stock is going to rise in the future, he can buy a futures contract at a price that would earn him profit.

Similarly, if a speculator believes that the price of a stock will fall, he can acquire a put option.

Also, it should be kept in mind that the successful use of these derivative products requires an in-depth understanding of the underlying mechanics.

These are essentially meant to preclude the capital required in a delivery-based system.

The dilemma

The problem is that the taxation depends upon the nomenclature of such transactions. Are these investment transactions? Or are these speculative transactions?

Speculative income, though taxed normally and not at any penal rate, nonetheless has certain restrictions imposed on it. We shall examine this in detail later.

However, it would be undesirable for a genuine bonafide investor to classify his normal investment income (or loss) as speculative.

Section 43(5) & Section 73

These sections are the main villains of the story. Let us see why.

Sec.43(5) defines a speculative transaction to be one which a contract for the purchase or sale of any stocks and shares, is periodically or ultimately settled other than by the actual delivery or transfer of the commodity or scrips.

However, the section has a proviso that goes on to state that any contract in respect of stocks and shares entered into by the dealer or investor, to guard against loss in his holdings of stocks and shares through price fluctuations, shall not be considered to be a speculative transaction.

Two points worthy of note

• Firstly, Sec. 43(5) specifically mentions stocks and shares. It does not refer to derivatives. Derivative instruments, though reflecting the underlying scrip, remain separate and distinct from stocks and shares.

That is the reason why Sec. 2(h) of the Securities Contract Regulations Act (SCRA) was amended to incorporate therein subsection (ia) which specifically includes derivatives in the definition of 'securities'.

Ergo, are we to conclude that since Sec. 43(5) does not mention derivatives, transactions in the same cannot be under the ambit of speculative transactions?

• Secondly, the proviso seems to suggest that any derivatives transaction meant as a hedging mechanism to avoid future losses cannot be deemed a speculative transaction.

However, any other dealing which is purely investment oriented (as against an hedging mechanism) will be deemed to be a speculative transaction.

At the same time, the definition seems to suggest that if a contract is settled otherwise than by actual delivery or transfer, it would be termed as a speculative transaction.

This Catch-22 situation, where one can argue both ways, ultimately works to the disadvantage of both the assessee and the department.

A Central Board of Direct Tax (CBDT) clarification is urgently needed.

Now, if these transactions are deemed non-speculative, then obviously they fall under capital gains. Since the contracts entered into are for less than one year, any gains or losses would be short-term in nature.

Short-term gains are added to the other income and taxed in the normal course. Short-term losses can be adjusted against other short-term or long-term gains.

Sections 70, 71 & 73

However, if the derivative transactions indeed result in speculative income, then how would they be taxed?

Firstly, Sec. 70 allows the assessee to set off losses from any source falling under any head of income against his income from any other source under the same head.

Sec. 71 allows balance losses under one head of income to be setoff against income under any other head.

Sec. 73 deems that speculation loss to be an exception in both the above cases, in that, speculation loss can only be set-off only against speculation profit.

Any unabsorbed loss can be carried forward for a maximum of eight years to be set-off against speculative income only.

To sum up

Needless to observe, such punitive treatment of speculation profit and loss makes this nomenclature undesirable for any income.

In any case, one wonders why the word 'speculation' is viewed as an anathema by the authorities. A certain amount of speculation is not only inherent in any market but also healthy.

Besides, it is a well-accepted principle, even by our parochial lawmakers, that a healthy and vibrant stock market is a barometer of the health of our economy.

In that case, isn't it crucial for the policy makers to formulate clear, easily definable guidelines that minimize if not eliminate any kind of doubt?

It's been over two years. All that was required was a clarification. Is this too much to ask?