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Derivatives and index futures

Subject : Derivatives
Month-Year : Jun 2001
Author/s : Nitesh S. Joshi
Advocate
Topic : Derivatives and index futures
Article Details :

A derivative is a product whose value is derived from the value of underlying variables, like asset, index or reference rate. A derivative is a risk management tool essentially to facilitate hedging of price risk of the underlying asset and are in the form of forward or futures contracts. A ‘forward’ contract is an agreement to buy or sell an asset on a specified date at a specified price. They are normally traded outside the purview of the exchange. Forward contracts suffer from certain limitations in the form of lack of centralisation of trading, illiquidity and counterparty risk. Futures markets are designed to solve the problems that exist in forward market. A ‘futures’ contract, like a forward contract, is an agreement between two parties to buy or sell an asset on a specified date at a specified price. Futures contracts are normally traded on an exchange. For this, the exchange specifies certain standardised features of the contract and it also provides a mechanism which gives the two parties a guarantee that the contract will be honoured.

The L. C. Gupta Committee, appointed to recommend appropriate regulatory frame-work for the introduction of derivatives has in its report expressed that, there are 4 kinds of derivatives instruments i.e., stock index futures, stock index options, individual stock futures and individual stock options of which, stock index future is the most preferred derivative, giving the reasons for the same. It also highlights the representa-tions made by mutual funds and other financial institutions on how these instruments may be useful for strategic purposes of controlling risk or restructur-ing portfolios (hedging technique). It also says that, mutual funds should not use derivatives for the purposes of speculation and that the trustees of each mutual fund should lay down a formal policy and detailed rules so that derivatives could be used for risk reduction or for strategic portfolio restructuring. Further to the above report, SEBI before approving the introduction of index futures trading, appointed J. R. Varma Committee to re-commend risk containment measurers in the Indian stock index futures market. The salient features of this report are that, it prescribes the methodology for fixing the initial margin on index futures contracts and accounting for daily changes in the same. It also lays down the liquidity net worth requirements for brokers and other participants involved in such transactions.

With a view to implement the above recommendations, Securities Contract (Regulation) Act, 1956 has been amended so as to insert derivative in the definition of ‘security’. ‘Derivative’ in turn has been defined to include a contract which derives its value from the index of prices of underlying securities [see S. 2(aa) and S. 2(h) of Securities Contract (Regulation) Act, 1956]. Further, by way of abundant caution, S. 18A has also been inserted in the said Act legalising contracts in derivatives, if they are traded on a recognised stock exchange and settled by the clearing house of the recognised stock exchange in accordance with the rules and bye-laws made by such exchanges in this behalf. The fear was that agreements in derivatives may be treated as wagers u/s.30 of the Indian Contracts Act, 1872 and hence such agreements may be treated as void and unenforceable.

Traders of derivative securities can be categorised as hedgers, speculators or arbitrageurs. Whereas hedgers are interested in eliminating an exposure to movements in the price of an asset, speculators wish to take a position in the market for making a profit. Even the L. C. Gupta Committee report recognises the fact that, hedging will not be possible, if there are no speculators. Arbitrageurs are interested in looking in a riskless profit by simultaneously entering into transactions in two or more markets.

In index futures for every buy contract there has to be an equal and opposite sale contract by another person. Currently, NSE allows contracts of 1, 2 and 3 months maturity levels. Each contract has to be carried on upto its maturity and upon maturity, difference between contract price and current prevailing price on the date of maturity has to be either paid or received depending upon whether it is a buy contract or a sale contract, e.g. a person enters into a buy contract at value 100 and on the date of maturity the spot price is 105 then, the buyer has gained 5 while the seller has lost 5 and vice versa if the spot price is lower then the contract price. Contracts in index futures may also be transferred before maturity and then the buyer of this contract would be under an obligation to fulfil the contract.

 

There are several issues arising out of index futures under the

Income-tax Act, 1961 (hereinafter referred to as ‘the Act’).

 

A. Income from transactions in respect of index futures would be ‘profits and gains of business’ or ‘capital gains’ :

Whether the transactions in index futures could be regarded as business of the assessee would depend upon the volume, frequency, continuity and regularity of transactions of purchase and sale in the index futures. A transaction in the course of business would result in business income. Whereas, if the transaction in index futures is considered as an investment, then the income therefrom shall be considered as capital gains. One interesting aspect of this matter is that, the basic purpose behind transactions in index futures is risk management by way of hedging, thus, where these transactions are entered into, to guard against loss due to price fluctuation in the stock market in respect of capital investments, it shall be on capital account and if the transactions in index futures are entered into to guard against loss in respect of stock-in-trade, it shall be in the course of business. Since, currently, index futures are allowed to be contracted only for one, two or three months’ maturity levels even if the transaction is regarded as on capital account, there is no advantage as such, as concessional rates of tax and indexation benefit are applicable only to long-term capital assets. However, the issue that may arise is that, if the transaction is regarded as on business account, then it will have to be further characterised as ‘speculative transaction’ or ‘other than speculative trans-action’, the consequence being any loss incurred in speculation business cannot be set off against any other income except from speculation business (see S. 73 of the Act) whereas, if the trans-action is regarded as on capital account, then there will be no issue on speculative transaction.

 

B. Accrual/Arisal of

income/(loss) :

Under the existing system, every person entering into index futures contract has to pay an initial margin in the beginning and also all open positions at the end of the day are daily settled at the mark-to-market settlement price. The initial margin is computed using the concept of value-at-risk and daily settlement is done at the settlement price for the day. Minimum level for initial margin is set by the exchange. Individual brokers may require greater margins from their clients than those specified by the exchange. However, brokers cannot accept lower margin than those specified by the exchange. The effect of the marking to market is that a futures contract is settled daily rather than all at the end of its life. At the end of each day, the investor’s gain/(loss) is added to/subtracted from the margin account. To illustrate

Suppose, Mr. X on Day 1 enters into a contract for sale of 100 indices at contract to be settled at a price of 1020 on Day 30 and deposits the initial margin with the broker of 10,200 (i.e. 10% of 1020 x 100, if the initial margin is 10% of the contract value).

On Day 2, as per the daily settlement Mr. X’s account will be debited in the books of the broker by 1000 which is the loss for the day on account of rise of the index and he will have to deposit 1000 with the clearing member/broker thereby result-ing in account balance of 10200. Further, on Day 3 on account of fall in the index Mr. X makes a profit of 2000 which is credited to his account which he is entitled to withdraw. (For daily settlement on mark-to-market basis each day’s price has to be compared with the immediately preceding day’s price). On Day 4, Mr. X’s account is debited with the loss of 1500 where after his account balance gets reduced to 10,700. Hence, on each day the account balance of the person after crediting/debiting the profit/(loss) respectively for the day should not go below the initial margin and if it goes, the person has to replenish the same and if there is anything in excess of the initial margin in his account, then he is entitled to withdraw the same. Here the question arises on, whether the profit/(loss) accrues on a daily basis or on maturity/offset prior to maturity. In my opinion, though the investor is under an obligation to deposit the short-fall in the initial margin on account of loss and is entitled to withdraw the surplus on account of gain on a daily basis, no profit/(loss) could actually accrue or arise before the maturity/offset prior to maturity. Profits/(losses) could accrue or arise on a daily basis only if the transactions are closed at the end of each day by an equal and opposite transaction and a fresh transaction is opened again at the beginning of the subsequent date, which is not the case in index futures. Further, though on few days the investor may make profit on daily basis, the transaction may end up in a loss at the time of maturity and vice versa and therefore the profit/(loss) determined on a daily basis is only of a contingent nature in-capable of estimation. Further, the reason for taking initial margins and daily settlement is to ensure smooth settlement of the transactions and to reduce the risks of non-payment on account of investor regretting the deal and trying to back out or simply not having financial resources to honour the agreement. The system of initial margin and daily settlement on the mark-to-market settlement basis is a form of measure provided by the exchange to guard against counterparty risks.

 

C. Business income (Stock-in-trade) :

A futures contract is an agreement to buy or sell an asset on a specified date for a specified price. A person is said to have taken a long position when he agrees to buy the index on a specified date while he is said to have taken a short position when he agrees to sell the index on the specified date. So, in a way whether the person takes a long position or a short position, he always buys the contract of index future i.e. when he takes a long position he ‘buys’ a ‘buy contract’ thereby agreeing to buy the index on a specified date for a specified price and when he takes a short position he ‘buys’ a ‘sale contract’ thereby agreeing to sell the index on a specified date and for a specified price, therefore, in all the events he holds a contract, either a ‘buy contract’ or a ‘sale contract’. Also index futures are considered as securities under the Securities Contract (Regulation) Act, so these are securities having value. Issue may arise when this transaction is a business one, as to whether the contracts would form part of stock-in-trade and, if so, valuation of the same at the end of the accounting period. I would think in the case of a trader, these contracts should form part of his stock-in-trade. The purpose of crediting the value of unsold stock as closing stock in the profit and loss account is to balance the cost of stock entered on the other side of the account at the time of their purchase, so that the cancelling out of the entries relating to the same stock from both sides of the account would leave only the transactions on which there have been actual sales in the course of the year, showing the profit or loss actually realised on the year’s trading. Hence, if there is any cost, then the transaction will have to be shown both on the debit side of the profit and loss account as purchases and on the credit side as closing stock. There is also a well-settled principle that closing stock should be valued at cost or market price, whichever is lower [see Chainrup Sampatram v. CIT, 24 ITR 481 (SC)], therefore, anticipated losses on these contracts may be claimed as a loss whereas unrealised gains will not be liable to tax. Next question is, what should be the cost of these securities. Upto the date of maturity, the investor holds an index future i.e. a right to buy or sell the index on the specified date at a specified price. While on the date of maturity in the case of buy contract, the index should be deemed to have been bought at the specified contract price and sold immediately at the current prevailing price. The investor either receives or pays the difference and the transaction gets squared off. Similar is the situation with sale contracts. Therefore, the index future that is held upto maturity and the index which is bought or sold on the date of maturity are two different securities. The specified contract price i.e. agreed upon whilst entering into the trans-action of index future is the price agreed upon for transacting the index on the date of maturity, while there is no method of ascertaining the cost of index future. Unlike forward and futures contract where the holder is under an obligation to buy or sell the underlying asset, the ‘options contract’ gives the holder the right to do something while he is not under an obligation to exercise this right. Also, it costs nothing to enter into a forward or futures contract while the investor has to pay to purchase an option contract. Therefore, though an investor has to incur a cost for entering into an options contract, no such element of cost is involved in a forward or futures contract.

The occasion for valuation of stock would arise only in respect of index futures, that have not yet matured. Though the index futures may be regarded as stock-in-trade, until their cost could be ascertained, they would not be capable of valuation.

 

D. Speculative transaction :

The issue on the transaction being regarded as speculative in nature [see S. 43(5)] would arise only if the transaction is regarded as of a business nature as against capital investment. For being regarded as a speculative transaction, the transaction has to satisfy two conditions :

(i) it should be a contract for the purchase or sale of any commodity, including stocks and shares and

(ii) the contract should be periodically or ultimately settled otherwise than by actual delivery or transfer of the commodity or scrips.

A transaction in index future is a contract for the purchase or sale of index on a specified date for a specified price. Now, in so far as the first condition is concerned, index futures cannot be regarded as stocks or shares but, the only issue is, can it be regarded as a commodity. Commodity has been defined by the Oxford English Dictionary, second edition, Vol. III at page 564 to mean ‘a property of the person’, ‘a thing of use or advantage to mankind esp. in plural useful products, material advantages, elements of wealth’, ‘an article of commerce’, ‘an object of trade; in plural goods, merchandise’. Contracts in index futures are regarded as securities under the Securities Contract (Regulation) Act and should also be considered as property having value since, one party to the contract can enforce the transaction against the opposite party and make him buy/sell the index on the specified day at the specified price. It is worth noting that, the Bangalore Bench of ITAT in Comfund Financial Services (I) Ltd. v. Dy. CIT, 67 ITD 304 has held, units of UTI to be a commodity, where it has relied upon the decision of the Court of Appeal in Imperial Tobacco Co. of Great Britain and Ireland Ltd., 25 TC 292 where dollar i.e. currency has been held to be a commodity. Some support can be taken from the decision of the Calcutta High Court in CIT v. Nirmal Trading Co., 82 ITR 782 where, it has been held that, letters of renunciation, is neither shares nor commodities, to say that index future should not be regarded as commodity. But, in conclusion, I am of the opinion that, there is a likelihood that index may be regarded as a commodity.

Coming to the second condition, a transaction will not be regarded as speculative in nature, if periodically or ultimately the contract is settled by actual delivery or transfer of the index. Does it contemplate that, this condition can be required to be fulfilled only if the commodity is capable of delivery or transfer. Index cannot be delivered and on maturity what happens is the working out of the rights and cannot be termed as transfer. Therefore, the condition of delivery or transfer would apply only if the commodity is capable of the same. ‘Lex non cogit ad impossiblia’. It is a well-settled principle of law that, the law does not compel a man to do that which he cannot possibly perform.

Hence, though index may be regarded as a commodity, still transactions in index future should not be regarded as speculative in nature as they are not capable of delivery or transfer. Further, as stated hereunder, if working out of transaction on maturity is regarded as transfer, then again, the transaction cannot be treated as speculative transaction as the provisions of S. 43(5) of the Act are complied with.

 

Explanation to S. 73 should not have an application, as it applies only in the case of purchase and sale of shares and index futures cannot be regarded as shares.

 

E. Capital gains :

If the transaction is on capital account, then the liability towards capital gains will have to be looked into from the following perspectives :

(a) Whether index future can be regarded as a capital asset ?

(b) Is there any transfer involved in the transaction ? and

(c) Is the cost of acquisition of index future ascertainable ?

 

In so far as issue (a) is concerned, index futures are regarded as security under the Securities Contract (Regulation) Act, 1956 and also they are property of value. Hence, index futures should be regarded as a capital asset.

Issue (b) will have to be examined in two situations :

(i) On the date of maturity, and

(ii) transfer before the date of maturity.

In so far as transfers of index futures before the date of maturity are concerned, un-doubtedly, a transfer is involved. Now as regards, squaring off of the transaction on the date of maturity one view is that, it should be regarded as working out of rights and hence no transfer is involved. However, there is also another view that is possible. Whenever a person enters into a buy contract prior to selling, it is characterised as ‘Buy Open’ and at the time of maturity respective sale order is entered as ‘sell close’ and vice versa when a person sells prior to buying. Whenever a person enters into a ‘buy contract’, he agrees to buy the index on a specified date for a specified price, now at the time of maturity it should be deemed that he has purchased the index at the specified contract price and immediately sold the same at the current prevailing price and, therefore, either he shall make a profit/(loss) depending upon the current price pre-vailing on the date of maturity and the contract price. Hence, when the contract is worked out on the date of maturity, it should be either regarded as sale or, in the least as relinquish-ment of an asset. This view may be further supported by the decision of the Supreme Court in the case of Anarkali Sarabhai v. CIT, 224 ITR 422 wherein redemption of preference shares have been treated as sale and relinquishment of the asset.

Lastly, in respect of issue (c), it is well settled principle of law that, the charging Section and the computation provisions together constitute an integrated code and when there is a case to which computation provisions cannot apply at all, it is evident that such a case was not intended to fall within the charging Section [see, CIT v. B. C. Srinivasa Setty, 128 ITR 294 (SC)]. As stated earlier, under the heading ‘C-Business income’ unless the cost of index future could be ascertained, the amount chargeable to tax under the head capital gains could not be worked out and hence such transactions may not be liable to capital gains. Except, if the brokerage paid at the time of entering into the transaction is regarded as cost of acquisition for acquiring the index future.

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