Taxation of derivatives and shares in India – Trading in future & options, intraday and stock held for short term and long term by an individual

As per the Indian income tax regulations, purchase of shares made with the objective of earning profit is considered as a business activity, whereas purchase of shares made with the intent of earning income through capital appreciation is considered as an investment activity.

Hence, if an individual derives income from Intraday trading, Futures & Options (F&O) and also from shares held with an investment objective, then he shall have 2 portfolios. Income from intraday trading and F&O would be categorised as ‘Business Income’ whereas gains from sale of shares held with the intent of earning capital appreciation would be categorised as ‘Capital Gains’.

We shall discuss each of this category in detail below:

A. F&O and Intraday activities

1. Categorisation as non-speculative and speculative business:

Business income derived from derivative transactions i.e F&O and intraday can be categorised as follows:

a) F&O profit or losses shall be treated as non-speculative business income or losses,

b) Equity intraday profit or losses shall be treated as speculative business income or losses.

In both cases, a profit and loss statement and a Balance Sheet of the business will need to be prepared and taxes will need to be determined. In determining the profits or losses, business expenses like internet, depreciation on laptop, mobile bills, brokerage, stamp duty, service charges, audit fee, etc can be considered as expenses and net profit or loss can be derived accordingly. Taxpayers should have invoices or bills to support these expenses because they are verified by the chartered accountant during an audit process.

2. Applicability of tax audit (for the financial year 2020-21):

Applicability of tax audit needs to be observed while doing F&O and intraday transactions since such transaction are designated as business activities. Applicability of tax audit can be observed as follows:

a) If your trading turnover is more than Rs. 5 Crores: Mandatory tax audit is required irrespective of whether you earned profits or losses.

b) If your trading turnover is less than Rs. 5 Crores

i. Scenario 1:

You incurred losses (or your profits are less than 6 percent of the turnover) and your total income is more than the basic exemption limit of Rs. 250,000 (eg: in situations where you have salary income alongwith trading losses) and you wish to claim such losses incurred – Tax Audit is required.

ii. Scenario 2:

You incurred losses (or your profits are less than 6 percent of the turnover) and your total income is less than the basic exemption limit of Rs. 250,000 (eg: in situations where you have salary or interest or rental income less than Rs. 2.5 lacs in total and also incurred trading losses separately) – No Tax Audit is required. Losses can be carried forward without an audit. However, a profit and loss statement and Balance Sheet of the business will need to be prepared for disclosure in the ITR.

iii. Scenario 3:

You earned profits and your profits are more than 6 percent of the turnover and your total income (including the above profit) is more than the basic exemption limit of Rs. 250,000 – No Tax Audit is required. Taxes will need to be paid on the profits earned based on your slab rates. Also, a profit and loss statement and Balance Sheet of the business will need to be prepared for disclosure in the ITR.

iv. Scenario 4:

You earned profits and your profits are more than 6 percent of the turnover and your total income (including the above profit) is less than the basic exemption limit of Rs. 250,000 – No Tax Audit is required. No taxes will need to be paid since your total income is less than the basic exemption limit. However, a profit and loss statement and Balance Sheet of the business will need to be prepared for disclosure in the ITR.

‘Turnover’ for the above purpose means:

° In the case of futures and intraday: Sum of absolute values of profits and losses.

°In the case of options trading: Sum of absolute values of profits and losses plus sum of sale value of the options

3. Choice to adopt presumptive provisions under section 44AD:

Under the four scenarios above and if your trading turnover is below Rs. 2 crores, you can choose to adopt the presumptive taxation scheme. Under this scheme, you will need to calculate a ‘presumed profit’ as 6% of the total turnover, categorise it as business income and pay taxes based on your slab rates. Also, presumptive method once adopted will need to be followed for 5 years.

Generally, taxpayers adopt presumptive taxation to avoid a tax audit, specifically in scenario 1 above. However, adoption of presumptive scheme needs to be taken with caution because 6% of turnover and tax on the same could turn out to be a hefty amount of tax payment (irrespective of losses incurred). Also, losses incurred are not allowed to be carried forward. Hence, under scenario 1, the taxpayer may choose between tax audit and presumptive taxation, based on whichever is more beneficial in his/ her case.

Recommendation for Tax Audit: For those assessees whose turnover value is high and the losses are substantial, tax audit is recommended. Tax audit also reduces the risk of scrutiny from the tax department as your transactions are verified, audited and approved by a practicing chartered accountant. Trust is placed on your verified transactions and the need for additional checks are not warranted by the tax department.

Recommendation for presumptive taxation scheme: Generally, adoption of presumptive taxation is recommended for those whose turnover value for the subject year is low, carry forward of losses is not the objective and the assessee doesn’t intend to trade much in the future.

4. Carry forward of losses

In case you have losses from derivative transactions and you are not adopting the presumptive taxation provisions, losses can be carried forward for the below mentioned period:

1) F&O losses being non-speculative in nature can be carried forward for 8 assessment years,

2) Equity intraday losses being speculative in nature can be carried forward for 4 assessment years.

Carry forward of losses are possible only if the ITR is filed within the prescribed due date. Hence, assessees with losses should take care to file their ITRs within the due date so that the benefit of set off can be availed favourably in the future years.

5. Due date for filing of ITR

If tax audit is applicable, Tax Audit Report in Form 3CD needs to be filed by the chartered accountant by September 30, 2021. Income Tax Return in ITR 3 needs to be filed by October 31, 2021. Digital signature for the assessee is mandatory in case tax audit is applicable.

If tax audit is not applicable or not opted for, then ITR needs to be filed by July 31, 2021.

B. Share Investment activities

Where the assessee is not involved in the derivatives market but invests in shares for a specific period of time, whether short term or long term, can be categorized as an investment activity. Income derived from sale of shares under this type of activity is categorised as ‘capital gains’.

From a taxation perspective, capital gains can be ‘short term capital gains’ or ‘long term capital gains’. We shall discuss each of these gains in detail below:

1. Short term capital gains

a) Listed shares:

If you are selling listed shares which you have held for a period less than 1 year, then the gain arising from such sale is called as short terms capital gains.

Short term capital gains on sale of listed shares is taxed at 15% under section 111A of the Income-tax Act.

Deductions under Chapter VIA cannot be availed in respect of short terms capital gains taxable under section 111A.

b) Unlisted shares:

If you are selling unlisted shares which you have held for a period less than 2 years, then the gain is arising from such sale is called as short terms capital gains.

Short term capital gains on sale of unlisted shares is taxed at applicable slab rates.

Deductions under Chapter VIA can be availed in respect of such short term capital gains.

2. Long term capital gains

a) Listed shares:

If you are selling listed shares which you have held for a period of more than 1 year, then the gain arising from such sale is called as long terms capital gains.

Long term capital gains on sale of listed shares exceeding Rs. 1,00,000 is taxed at 10% under section 112A of the Income-tax Act. Under this section:

• Benefit of indexation is not available

• Rebate under section 87A is not available

• Deductions under Chapter VIA are not available

Determination of cost of acquisition in case of listed shares: If the listed shares were acquired before 1.2.2018, then in computing the long-term capital gains, Fair Market Value (FMV) as on 01.02.2018 will need to be considered in the following manner for determining the Cost of acquisition:

Step 1: Compare Full Value consideration and FMV as on 01.02.2018 – Choose lower

Step 2: Compare Step 1 with the actual cost of actual acquisition – Choose higher

b) Unlisted shares:

If you are selling unlisted shares which you have held for a period more than 2 years, then the gain arising from such sale is called as long term capital gains.

Long term capital gains on sale of unlisted shares is taxed at 20% with indexation benefit under section 112 of the Income-tax Act.

• In the case of resident individuals, if the basic exemption is not exhausted by any other incomes, then the long-term capital gains is reduced by the unexhausted basic exemption limit and only the balance is taxed at 20%. This benefit is not available to non-residents.

• Non-residents are subject to tax at a concessional rate of 10% (without indexation benefit) on long term capital gains arising from transfer of unlisted shares.

Deductions under Chapter VIA cannot be availed in respect long term capital gains arising out of sale of unlisted securities.

Exemption from Long Term Capital Gains

Exemptions under section 54F, which is the only possible exemption which can be availed with respect to sale of shares, can be claimed only with respect to long term capital gains. There are no tax exemptions available for short term capital gains.

Under section 54F, if the net sale proceeds of the long term shares sold are invested in purchase of a new residential house, then the complete long term capital gains can be exempt. If a proportionate of the net sale proceeds is invested, then the long-term capital gains is exempt proportionately in the ratio of amount invested to net sale consideration.

The above article primarily discusses taxation from the perspective of shares. In case you are dealing with debt securities or debt funds, then the rates and treatment of tax will vary.