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Tax Audit Requirements for Futures and Options Trading

The National Stock Exchange of India is one of the busiest stock exchanges in the world when it comes to the trading of Futures and Options contracts. In the financial year 2021-22 itself, futures and options contracts worth USD 226,031 billion were traded on the NSE. Such huge volumes of trade obviously indicates that investments in futures and options contracts in India are extremely profitable. Even if the profit margins are negligible, investors still prefer trading in Futures and Options contracts as the risks of losses arising due to dynamic fluctuations in market prices are minimal.
Tax-Audit-Requirements-For-Futures-And-Options-Trading
Futures & Options traded in India are considered non-speculative financial instruments under the Income Tax Act, 1961. These instruments are traded to hedge future risks of losses arising from a sudden decline in prices of underlying assets, and thus, investors trading in such instruments are required to get their accounts audited for the purpose of payment of taxes. This article elaborates in detail ,the applicability of tax audits on the trade of Futures and Options in India, on the basis of profits earned and losses faced as a result of such trade.

Table of Contents

Classification of F&O transactions under the Income Tax Act, 1961

Since F&O trades are settled without facilitating any delivery of shares or underlying assets, they might appear to be speculative financial instruments. However, their classification is exactly on the contrary. In this context, let us first understand the transactions that are considered to be speculative in nature according to Section 43(5) of the Income Tax Act. Speculative Transactions are transactions where the sale of stocks and commodities are settled without their actual delivery to the buyer. However, there is a list of exceptions mentioned in the section, which includes trades in commodities and shares for the purpose of hedging future risks of losses. It is this exception on the basis of which Futures and Options contracts are classified. Since the trading of futures and options is also done for the purpose of hedging future risks, they are clearly classified as “Non-speculative transactions”, even though their trades do not involve any physical delivery of stocks or commodities. For all practical purposes like tax assessment, accounting, tax audits, and filing of income tax returns, trade in Futures and Options shall be considered “ Non-speculative” transactions. As no actual delivery of shares or underlying assets takes place on the completion of Futures and Options transactions, the traders have to book their profits or losses by either receiving or paying the concerned amount at the time of settlement

Meaning of Turnover in futures & options transactions under the Income Tax Act

The applicability of tax audit for futures and options transactions is determined on the basis of the turnover of such transactions. Therefore, it becomes extremely necessary for assessees to thoroughly examine their turnovers according to its definition mentioned in the Income tax Act.
The turnover for F&O transactions is calculated in the manner mentioned below.
  1. In the case of transactions that have been squared off, the aggregate of the favorable and unfavorable differences (i.e. profits + losses), is used to determine the resulting turnover of the transaction. Please do remember that losses are not to be subtracted from the profits, rather their numerical values are to be summed up to calculate the absolute turnover.
  2. The premium submitted in case of Options transactions is also added to the sum total of profits and losses, in order  to calculate the absolute turnover. Remember that this provision is only applicable to options trading and not to Futures trading.
  3.  The above mentioned values are to be added to the basic sale price of the futures and options contracts.
After having calculated the “Turnover” according to the process mentioned above, its value must be compared with the ceiling or threshold limits prescribed under law to determine the applicability of tax audit on the particular transaction.

Statutory provisions for the applicability of Tax Audit on F&O trading

The statutory provisions that determine the applicability of Tax Audit on F&O transactions have been mentioned in section 44 AB(a) and section 44 AB(e) of the Income Tax Act. According to the sections, there are two different grounds that prescribe mandatory tax audit for Future and Options trading.
  •  Provision for Tax Audit under Section 44 AB(a) of the Income Tax Act, 1961
    The provisions for tax audit mentioned in Section 44AB (a) prescribes the turnover limits for the applicability of tax audit on Futures and Options trading in India. Tax audit shall be mandatory for all F&O transactions exceeding the turnover limit of Rs.10 crores, irrespective of the profit gained or losses faced in such transactions.  Since, futures and options transactions are completely digital, the tax rate prescribed under section 44AD will be 6%, instead of 8% in all other cases. 
  • Condition for Tax Audit under section 44 AB(e) of the Income Tax Act, 1961
    A person carrying out F&O trading will have to necessarily get his accounts audited if section 44 AD(4) becomes applicable and his taxable income is in excess of what is prescribed as the basic exemption limit. In this context, Section 44AD (4) states that, if an F&O trader has opted out of the Presumptive Scheme of Taxation in the previous year, after having being enrolled under it in any of the 5 years immediately preceding the previous year, and if his accounts that particular year/s are showing losses or profits less than 6% of the turnover earned in the previous year, then tax audit becomes mandatory, even though the turnover for the previous year is below Rs.2 crores.  An additional point to be noted is that an assessee has the option to disclose his taxable income as 6% or more, of the turnover and remain free from any Tax Audit obligations, as long as his turnover does not exceed Rs. 2 the previous year, if he is currently enrolled under the Presumptive Taxation Scheme.
Tax Audit Applicability Presumptive Scheme opted and turnover is less than Rs. 2 crores Presumptive Scheme not opted and turnover is less than Rs.2 crores Presumptive Scheme previously opted and subsequently withdrawn, and turnover is less than Rs. 2 crores Turnover more than Rs. 2 Crores but up to Rs. 10 Crores Turnover more than Rs. 10 Crores
Tax Audit applied
No
No
Yes
No
Yes
Section applied
N.A.
N.A.
44AB(e)
N.A.
44AB(a)
Reason of applicability
In case of presumptive scheme opted for, no requirement of Tax Audit exists
The normal threshold limit prescribed under section 44AB(a) will apply
Section 44AB(e) says Tax Audit is to be done mandatorily if section 44AD(4) is applied
The normal threshold limit prescribed under section 44AB(a) will apply
As the turnover has crossed the normal threshold limit under section 44AB(a), Tax Audit becomes mandatory

Conclusion

Trading in stocks and commodities can be immensely risky owing the sharp fluctuations in its market prices. The need for hedging such risks attracts investors towards financial instruments like Futures and Options Contracts, both of which enables the buyers and the sellers to trade at a fixed future date, on a predetermined and mutually agreed prices. In case the pre-fixed prices are greater than the current market prices of the commodities or stocks traded, the risks for losses remain hedged. On the other hand, if the current market prices are less than the pre-fixed prices in the contracts, then the investors lose their chances of earning profits. In such scenarios, the cost of legal and tax liabilities like mandatory tax audit compliance adds up to the cost burden for investors. Therefore, it is recommended that investors trading in Futures and Options must have a thorough understanding of the tax audit and other related liabilities before making an informed decision on whether to trade in futures and options or not. In this regard, we hope that the information mentioned in this article was helpful to you.

About Setindiabiz

Setindiabiz is an organized team of experienced CA, CS, & Lawyers, duly supported by a pool of trained accountants & paralegal staff that provides quality & affordable compliance services to startups & small businesses in India. The views, statements and recommendations expressed in this article or post are only for the sole objective of providing information, and it does not constitute professional advice or recommendation of the company. Neither the author nor the company or its affiliates accepts any liability for any loss or damage arising from any information in this article or any actions taken in reliance thereon.

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