taxation and accounting of commodity derivatives

#3
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#4
Hi,
Taxation of derivatives in shares .

Whether derivatives are `capital assets' within the meaning of sec 2 (14) of the Income Tax Act ? The term `capital assets' means property of any kind held by an assessee, whether or not connected with his business or profession, but excludes stock in trade of the business &
few other items specified in the said section. As noted, the definition is wide & is held to include not only the property, but a right to acquire such property. Derivatives are securities as defined u/s 2(h) of Securities Contract (Regulation) Act, 1956, and therefore, property with value. Derivatives accordingly are capital assets, unless held as stock-in-trade of business. Futures & Options are contracts representing a property of value capable of being acquired, held & transferred, & have all the important ingredients of Capital Assets. Both types of contracts create rights & obligations & carry their own values.

Thus, derivatives can be taxed either under capital gains or as profits of the business. A constant tug of war is on to determine whether securities related income represents profits of the business or are capital gains. In some cases the dividing line is so thin that the issue can be better decided by a toss of a coin than by elaborate reasoning .

Some of the factors considered relevant are the length of the holding period, intention, regularity or the frequency, source of funds, the administrative set up, use of sale proceeds, circumstances leading to sale, accounting treatment, manner of acquisition, proportion of such
income & the overall time devoted for the activity.

Speculation business is defined in sec 43(5). Clause (d) of the proviso to section 43(5) provides an exception for certain eligible transactions of derivatives w.e.f. assessment year 06-07. Such exclusion of derivatives transactions is however, subject to certain
conditions. These conditions, in short, are:

the transaction should have been carried out electronically on a screen based system;

the transaction should have been carried out through a share broker or a sub-broker;

the transaction should have been carried out on a recognised stock exchange i.e either BSE or NSE ;

the bill should have the PAN etc;

the client should possess a time stamped contract.

Can derivatives be treated as non-speculative even when entered into prior to A.Y 06-07. Since the exclusion from speculative is subject to many conditions, the amendment cannot be considered as clarificatory & therefore retrospective. It can only be held to be prospective.

Derivatives, though securities, are financial contracts without any physical existence.

Equity stock options & equity stock futures cannot be settled by delivery, but can only be cash settled. A transaction backed by actual delivery is not treated as a speculative transaction. The condition presupposes that it is actually possible to deliver the product. The law can prescribe only such conditions which are capable of being fulfilled & complied with. It cannot compel a person to do a thing which it legally cannot perform. Such a condition if provided will be redundant. This is supported by the principle `Lex non cogit ad impossibilia'. Thus, even without clause (d) of the proviso to section 43(5), a derivative transactions could not have been regarded as a speculative transaction.

INCOME TAX ACT, 1961
Section 43 (5)1
Speculative transaction means 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 scrips:
Provided that for the purpose of this clause:
a. a contract in respect of raw materials or merchandise entered into by a person in the course of his manufacturing or merchanting business to guard loss against loss through future price fluctuations in respect of his contracts for actual delivery of goods manufactured by him or merchandise sold by him; or
b. a contract in respect of stocks and shares entered into by a dealer or investor therein to guard against loss in his holdings of stocks and shares through price fluctuations; or
c. a contract entered into by a member of a forward market or a stock exchange in the course of any transaction in the nature of jobbing or arbitrage to guard against loss which may arise in the ordinary course of his business as such member
Clause (d) of the proviso to section 43(5) provides an exception for certain eligible transactions of derivatives w.e.f. assessment year 06-07. Such exclusion of derivatives transactions is however, subject to certain conditions. These conditions, in short, are:

the transaction should have been carried out electronically on a screen based system;

the transaction should have been carried out through a share broker or a sub-broker;

the transaction should have been carried out on a recognised stock exchange i.e either BSE or NSE ;

the bill should have the PAN etc;

the client should possess a time stamped contract.

SECTION 73 Losses in speculation business
1. Any loss, computed in respect of a speculation business carried on by the assessee, shall not be set off except against profits and gains, if any, of another speculation business.
2. Where for any assessment year any loss computed in respect of a speculation business has not been wholly set off under sub-section (1), so much of the loss as is not so set off or the whole loss where the assessee had no income from any other speculation business, shall, subject to the other provisions of this chapter, be carried forward to the following assessment year,and:
i. it shall be set off against the profit and gains, if any, of any speculation business carried forward to the following assessment year; and
ii. if the loss cannot be wholly set off, the amount of the loss not so set off shall be carried forward to the following assessment year and so on.

3. In respect of allowance on account of depreciation or capital expenditure on scientific research, the provisions of sub-section (2) of section 72 shall apply in relation to speculation business as they apply in relation to any other business.
4. No loss shall be carried forward under this section for more than eight assessment years immediately succeeding the assessment year for which the loss was first computed.
Explanation. Where any part of the business of a company (other than a company whose gross total income consists mainly of income which is chargeable under the heads Interest on securities, Income from house property, Capital gains and Income from other sources or a company the principal business of which is the business of banking or the granting of loans and advances) consists in the purchase and sale of shares of other companies, such company shall, for the purposes of this section, be deemed to be carrying on a speculation business to the extent to which the business consists of the purchase and sale of such shares.
Section 28
Explanation 2 Where speculative transactions carried on by an assessee are of such a nature as to constitute a business, the business (hereinafter referred to as speculation business) shall be deemed to be distinct and separate from any other business.
INTERNATIONAL PRACTICES
Statement of Financial Accounting Standard No. 133 issued by the Financial Accounting Standard Board, US defines the criteria /attributes which an instrument should have to be called as derivative and also provides guidance for accounting of derivatives. The Standard is facing tough opposition and controversies from the US business and industry.
What is a Derivative?
The standard defines a derivative as an instrument having following characteristics:
A derivatives cash flows or fair value must fluctuate or vary based on the changes in an underlying variable.
The contract must be based on a notional amount of quantity. The notional amount is the fixed amount or quantity that determines the size of change caused by the movement of the underlying.
The contract can be readily settled by net cash payment
Accounting for Derivatives as per FAS 133
The standard requires that every derivative instrument should be recorded in the Balance Sheet as assets or liability at fair value and changes in fair value should be recognised in the year in which it takes place.
The standard also calls for accounting the gains and losses arising from derivatives contracts. It is important to understand the purpose of the enterprise while entering into the transaction relating to the derivative instrument. The derivative instrument could be used as a tool for hedging or could be a trading transaction unrelated to hedging. If it is not used as an hedging instrument, the gain or loss on the derivative instrument is required to be recognised as profit or loss in current earnings.
Derivatives used as hedging instruments
Derivative instruments used for hedging the fair value of a recognised asset or liability, are called Fair Value Hedges. The gain or loss on such derivative instruments as well as the off setting loss or gain on the hedged item shall be recognised currently in income.
Example
An individual having a portfolio consisting of shares of Infosys and BSES, may decide to hedge this portfolio using the Sensex Futures Contract. The gain or loss on the index futures contract would compensate the loss or gain on the portfolio. Both the gains and losses will be recognised in the Profit and Loss Statement. If the hedge is perfect, gains and losses will offset each other and hence will not have any impact on the current earnings. However, if the hedge is not a perfect hedge, there would be a difference between the gain and the compensating loss. This would affect the current reported earnings of the individual.
If the derivative instrument hedges risk of variations in cash flow on a recognised asset and liability, it is called Cash Flow hedge. The gain or loss on such derivative instruments will be transferred to current earnings of the same period or the periods during which the forecasted transaction affects the earnings. The remaining gain or loss on the derivative instrument if any shall be recognised currently in earnings.
Similarly if the derivative instrument hedges risk of exposures arising out of foreign currency transactions or investments overseas or in subsidiaries, it is called Foreign Currency Hedge.
Hedge Recognition
Accounting treatment for trading and hedging is completely different. In order to qualify as a hedge transaction, the company should at the inception of the transaction:
Designate the hedge relationship
Document such relationship
Identifying hedge item, hedge instrument and risks being hedged
Expect hedge to be highly effective
Lay down reasonable basis for assessment effectiveness. Ineffectiveness may be reported in the current financial statements earnings.
Earlier there was no concept of partial effectiveness of hedge. However FASB recognised that not all hedging transactions can be perfect. There can be a degree of ineffectiveness which should be recognized. The Statement requires that the assessment of effectiveness must be consistent with risk management strategies documented for that particular hedge relationship. Further the assessment of effectiveness is required whenever financial statements or earnings are reported.
Conclusion
The Indian accounting guidelines in this area need to be carefully reviewed. The international trend is moving towards marking the underlying securities as well as associated derivative instruments to market. Such a practice would bring into the accounts a clear picture of the impact of derivatives related operations. Indian accounting is based on traditional prudence where profits are not recognised till realisation. This practice, though sound in general, appears to be inconsistent with reality in a highly liquid and vibrant area like derivatives.