While currency markets have been active in India for a long time in the form of spot market and the forward market, the currency trading in exchange were only permitted in 2008. Post the Lehman crisis, the need was felt to allow Indian traders to hedge their risk with currency exposure, especially when a weak rupee was driving down equity returns. Today, online trading in currency futures and options on rupee pairs and also on cross currency pairs are actively traded on the BSE and the NSE.
We now move to the subject of taxation of such currency derivatives. Should it be treated as speculative or as an investment and whether one is liable to pay capital gains tax or show it as business income? It must be noted that there is a significant difference in the tax treatment of security derivatives and commodity derivatives (since commodity derivatives permit square off and delivery transactions). Let us now look at it from a currency derivatives perspective.
Currency trading versus commodity futures trading
Before getting into the taxation aspect, here are a few things to remember.
- Like equity and index derivatives, currency derivatives are traded on stock exchanges and not on commodity exchanges.
- Currency derivatives cannot be settled by physical delivery, but only cash settled; irrespective of whether it is a rupee pair or a cross currency pair.
- Since the currency derivatives are also settled by payment of differences, should currency derivatives be treated for tax purposes at par with equity derivatives?
- Will the transactions in currency derivatives be regarded as speculative transactions or as normally business / deemed delivery transactions?
Settling the currency derivatives taxation debate
There are two ways to look at it. Firstly, currencies have physical presence and hence are at par with commodities. Secondly, they are cash settled and hence are structurally more akin to equity derivatives.
Let us first evaluate if currency derivatives are speculative in nature and for that let us get back to the definition of speculative transactions. The definition of speculative transaction under the tax laws has an exception for transactions in respect of trading in derivatives referred to in section 2(ac) of the Securities Contracts (Regulation) Act (SCRA) carried out on recognized stock exchanges. The larger issue therefore is whether a currency derivative is a derivative as defined under SCRA. Currency derivative transactions are carried out on stock exchanges, and not on commodity exchanges and would, therefore, not be regarded as speculative transactions if they qualify as derivatives defined under SCRA.
Let us now turn to the definition of derivatives under SCRA. The definition is comprehensive and all-encompassing and includes all sorts of derivatives, not just derivatives whose value is linked to underlying securities. The very fact that currency derivatives are traded on stock exchanges indicates that they are securities, one type of security being a derivative. Although the currency derivatives are derived from the value of an underlying currency which is not trade on the exchange spot, the fact that the derivative is traded on the stock exchange makes it a security under the SCRA. Hence, currency derivative transaction will rank at par with equity and index derivatives for tax purposes.
Business income versus capital gains – taking a view
From the above discussion, it is quite clear that currency derivatives will not be classified as speculative income. Therefore, profit or loss derived from trading in currency derivatives would have to be treated either as capital gain / loss or as business income. As a result, commodity derivatives trading losses or day trading losses, which are classified as speculation losses, cannot be set off against income from trading in currency derivatives, which is treated as regular income.
Can you treat the profits / losses on currency derivatives as capital gains? The answer is you can; if the transactions are small in size and the frequency of transactions is not too much. In such cases, you can treat the same as short term gains / losses and adjust them accordingly. However, currency derivatives transactions are generally entered into as part of normal business transactions, such as to hedge business transactions by exporters and importers. Most transactions in currency derivatives are by businesses for hedging purposes and, therefore, in such cases there is little to debate that the currency derivatives transactions would be treated as part of normal business transactions.
Once you classify as business there are three things you must remember. Firstly, only the net gains after adjusting for losses are taxable and the losses can be carried forward for a period of 8 successive years. Secondly, you have the choice to mark to market the losses (not gains) at the end of the year. Lastly, where transactions by business hedgers in an individual capacity, it can be classified as income from other sources.