Taxation of derivatives

The Income Tax Ordinance, 2001, promulgated on 13th September 2001 and made effective from 1st July 2002 in Pakistan, does not define 'derivative financial instruments' which are flexible tools for financial engineering and speculators.
This article deals exclusively with the tax issues relating to these products. The derivatives markets have become more and more noteworthy in the 1990s and since then have continued their relentless development.
These markets pose a great challenge for the legislators and regulators in providing reliable mechanism for safeguarding the rights and interests of all the stakeholders.
In the Pakistani context, the State Bank of Pakistan (SBP) and Securities and Exchange Commission (SECP) in recent years have enacted a number of rules and regulations to streamline the issuance and operation of such instruments.
The importance of these instruments and their likely effects on Pakistani capital markets, financial sector and overall economy can be gauged from the fact that a full session is allocated to discuss 'Derivatives in Pakistan' at a two-day 'International Conference on Investment Banking' to be held in Karachi (January 17 and 18, 2004).
It is distressing to note that the issue of taxation of financial derivatives under the Pakistani tax laws has been completely ignored in the coming conference, which is going to be attended by luminaries of corporate, banking and financial sectors.
The reason for ignoring the vital are of taxation is best known to the organisers of the workshop, but it shows that in Pakistan there is very little knowledge about the tax consequences of these highly complex products.
The taxation of these products is more complex than the complexity intrinsic in their nature, purpose, and execution.
The Income Tax Ordinance, 2001 [hereinafter: "the Ordinance"] although comprehensively lays down the methodology of computation of taxable income but provides no specific guidance with respect to financial derivatives.
Therefore, the tax treatment of financial derivatives are to be deduced from the application of the general rules of income taxation set out in the Ordinance and as interpreted by the courts in other context (eg hedging transactions, foreign exchange gains and losses, and the characterisation of financing charges).
Before discussing the various tax issues relating to derivatives, it seems necessary to give a brief summary of their nature, purpose of utilisation, definitions and other related issues. These are extracted from the book, The law on Financial Derivatives by Alastair Hudson, 2nd Edition, Sweet & Maxwell, London, 1998.
"WHAT IS A "DERIVATIVE"? The term 'derivative' does not have a precise definition. A derivative product is a financial product that is derived from another financial product.
For example, an option to buy a share at some point in the future is a financial product derived from the underlying share. Similarly, a swap on an interest rate is a product derived from the underlying loan. Hence the term "derivative".
WHY ENTER INTO A DERIVATIVE? The fundamental question is to explain why a derivative product is necessary in any event.
The goal of all derivative products is to obtain funding at a preferential rate or to take speculative advantage of a movement in a financial market for the investing institution.
The derivative market as we understand it in the late 1990s grew out of the exchange control motivated transactions considered above.
The modern context of the market is more complicated than straightforward regulatory avoidance.
Estimates of the size of the derivatives markets across the world are somewhere in the region of US$ 55 trillion. There are four basic forms of activity:
1. Speculation
2. Hedging
3. Asset liability management
4. Arbitrage
The following terms are important to understand the nature and scope of the derivatives.
COMPLEX OPTIONS: Options which are combinations of option strategies designed to achieve more specific goals than vanilla option products.
CREDIT DERIVATIVE: Complex form of derivative product where the price of the derivative is related to the credit worth of a reference entity.
Thus an investor acquires an exposure to, or hedge against, the changes in the credit worth of a specified entity.
CROSS-CURRENCY INTEREST RATE SWAPS: An option to purchase or to sell an amount of a currency at a given price at a given time in the future.
CURRENCY SWAP: A transaction in which cash flows in different currencies are exchanged between counter-parties, enabling a party to obtain amounts of foreign currency at a lower funding rate.
EQUITY SWAPS: The structure is usually for the payment of a fixed amount of money by one party the other in return for a floating amount.
For example, X might wish to speculate on the performance of the Nikkei 225 index against LIBOR.
Therefore X would seek to pay LIBOR to Y and in return receive from Y the cash equivalent of the performance of the Nikkei 225 over a given period of time.
The benefit to X is a receipt of cash flow equal to the performance of the Nikkei 225 without the expense or administrative difficulties of purchasing a range of stocks appearing on the Nikkei 225.
EQUITY WARRANTS: A form of issued instrument in the primary markets which bears similarities to an equity option but which is issued by the company itself and requires the company to issue new equity on its exercise.
FINANCIAL RISK: The risk that the underlying or relevant derivative market will move with the result that the derivative product moves out-of-the-money.
FORWARDS: The forward is a promise to supply a particular commodity or security at a set price on a set date (often in a set place).
In the commodity markets it is usual to buy wheat, for example, at a given price in a given amount at a pre-determined time to be delivered in a given place.
In the time it takes for the contract to mature (which might include the wheat to grow be harvested and shipped) the price of wheat can fluctuate wildly.
The contract, that is the right to receive the wheat at a price at a time in the agreed place, can be sold to others at a greater or lower price than that paid for it originally.
The same is true, to a greater or lesser extent, of contracts entered into between private parties.
FUTURES: A forward conveys the right to purchase or sell a specified quantity of an asset at a fixed price on a fixed date in the future.
In exchange traded futures contracts, which are a standardised form of forward contract, the quantity of the underlying asset to be delivered per contract is fixed, as is the underlying financial instrument or index, the minimum price movement for the contract and the life of the contract.
FUTURES PRICE: The price that the market would pay the notional instrument representing the thing that is to be physically delivered if that thing existed currently.
The pricing for these instruments feels a little counter-initiative at first meeting.
The prices are quoted as an amount (100) less the implied interest rate on that instrument.
Therefore, the price of a futures instrument moves in inverse correlation to movements in interest rates.
HEDGING: A strategy used to offset market risk. The use of derivatives to hedge financial risk, involves investment in a derivative instrument in which market movements will offset movements in the primary investment.
HEDGE FUNDS: A form of low capitalised, highly-leveraged mutual fund which uses hedging techniques as an important part of their trading activities to control financial risk and to enable greater leverage on capital resources to fund market speculation.
INVERSE FLOATER SWAPS: Inverse floater swaps aim to take advantage of a steep yield curve, that is where interest rates are expected to rise steeply in the future and therefore there is a great difference between short term interest rates and long term interest rates.
INTEREST RATE SWAPS: An interest rate swap is an agreement between parties to make periodic payments to the other party in the same currency.
Where A and B can obtain different costs of funding which may not suit their own commercial circumstances, if they can exchange their available terms to their mutual advantage, this is a useful way for them to do business.
NETTING: The process of setting off obligations under transactions one against another so that payments between parties are made net rather than gross.
One of the most important issues facing the derivatives lawyer is the availability of netting in the event that one of the parties to a derivatives transaction becomes insolvent.
NOTIONAL AMOUNT: The notional amount by which the size of payments made under a swap transaction are calculated.
OTC DERIVATIVES: Derivatives which are transacted privately between parties rather than traded on an exchange.
PHYSICAL DELIVERY: Physical delivery of an option requires that, when the option is exercised, the underlying financial product is delivered to the counter-party rather than its cash equivalent.
RISK MANAGEMENT: The process of assessing and controlling credit risk in financial institutions.
The Risk Management procedure involves a combination of credit risk evaluation and portfolio management.
SECURITIZED OPTIONS: The process of securitization of assets has grown as a market product.
Securitisation involves the bundling together of financial instruments which are then sold.
Option products are capable of being turned into securities in this way and sold as a single asset.
STOCK OPTIONS: A put or call option with reference to underlying shares traded, in most circumstances, on an exchange.
SWAPS: A swap is simply an exchange of the rate of interest that a borrower is paying for a different rate of interest.
Company A will agree to pay the interest on the debt it owes to B bank, in return for which Company A will pay a different rate of interest to the Bank C with which it has entered into the swap.
This is a simple exchange of cash flows for a fee.
SWAPTIONS: An option to enter into a swap transaction. Usually purchased by a client to provide protection against future movements in interest rates by enabling the client to initiate a swap transaction at a given rate for a given maturity.
TAX DERIVATIVES: A form of derivative product using swap and option techniques to reduce the client company's exposure to tax.
The product's aim is to restructure the client's cash flow to produce a more tax efficient form of cash flow.
The term "tax derivative" is therefore something of a misnomer, being a complex derivative adapted for a particular purpose".
TAXATION OF DERIVATIVES UNDER IT ORDINANCE 2001: From the standpoint of taxation under the Ordinance, the most crucial question is the classification of derivatives as 'stock-in-trade' or 'capital asset' in the hands of a taxpayer.
If a particular financial instrument is classified as 'capital asset' income or loss arising from its 'disposal' will be taxed under section 37 of the Ordinance which is called "Capital Gains'.
On the other hand, if a financial instrument constitutes 'stock-in-trade', income therefrom will be taxed under the head 'Income from Business' [section 18].
In case the dealing in these instruments constitute 'speculation business' [as defined in section 19(2)] such a business shall be treated as distinct and separate from any other business varied on by a taxpayer.
THE TERM 'CAPITAL ASSET' IS DEFINED EXCLUSIVELY IN SECTION 37(5) WHICH READS AS UNDER: "In this section, "capital asset" means property of any kind held by a person, whether or not connected with a business, but does not include -
(a) any stock-in-trade (not being stocks and shares), consumable stores or raw materials held for the purpose of business;
(b) any property with respect to which the person is entitled to a depreciation deduction under section 22 or amortisation deduction under section 24;
(c) any immovable property; or;
(d) any movable property (excluding capital assets specified in sub-section (5) of section 38) held for personal use by the person or any member of the person's family dependent on the person".
The significant aspect of this definition is that 'stocks' and 'shares' are treated as 'capital assets', even where held as stock-in-trade by a taxpayer.
This result in the taxation of the income arising from the disposal of such assets under section 37, and not income from business.
This issue was discussed in detail by the Income Tax Appellate Tribunal of Pakistan and held that even where a broker dealing in stocks and shares earn income from disposal of these commodities, he will be taxed under the head 'Capital Gains' and not under the head Income from Business.
The Central Board of Revenue (CBR) in Circular No 5 of 1960 also concluded that profits and gains from sale of stocks and shares are to be treated as capital gain, even in the hands of taxpayers who are engaged in the business of purchasing and selling of these items.
THE PRINCIPLES FOR COMPUTING CAPITAL GAINS ARE PROVIDED IN SECTION 37 OF THE ORDINANCE, WHICH READS AS UNDER:
"37. Capital gains.- (1) Subject to this Ordinance, a gain arising on the disposal of a capital asset by a person in a tax year, other than a gain that is exempt from tax under this Ordinance, shall be chargeable to tax in that year under the head "Capital Gains".
(2) Subject to sub-sections (3) and (4), the gain arising on the disposal of a capital asset by a person shall be computed in accordance with the following formula, namely:-
A - B: where A is the consideration received by the person on disposal of the asset; and B is the cost of the asset.
(3) Where a capital asset has been held by a person for more than one year, the amount of any gain arising on disposal of the asset shall be computed in accordance with the following formula, namely:-
A X 3/4: where A is the amount of the gain determined under sub-section (2).
(4) For the purposes of determining component B of the formula in sub-section (2), no amount shall be included in the cost of a capital asset for any expenditure incurred by a person-
(a) that is or may be deducted under another provision of this Chapter; or
(b) that is referred to in section 21.
INCOME FROM BUSINESS AND PROFESSION IS DETERMINED UNDER SECTION 18 WHICH SAYS:
"18. Income from business.- (1) The following incomes of a person for a tax year, other than income exempt from tax under this Ordinance, shall be chargeable to tax under the head "Income from Business"-
(a) the profits and gains of any business carried on by a person at any time in the year;
(b) any income derived by any trade, professional or similar association from the sale of goods or provision of services to its members;
(c) any income from the hire or lease of tangible movable property;
(d) the fair market value of any benefit or perquisite, whether convertible into money or not, derived by a person in the course of, or by virtue of, a past, present, or prospective business relationship; and
(e) any management fee derived by a management company (including a modaraba management company).
(2) Any profit on debt derived by a person where the person's business is to derive such income shall be chargeable to tax under the head "Income from Business" and not under the head "Income from Other Sources"."
The deductibility of expenses under the two heads is quite different. For computing income under the head 'Capital Gains' only limited expenses are allowed as envisaged in section 37(2) and section 39 that provide as under:
"(2) Subject to sub-sections (3) and (4), the gain arising on the disposal of a capital asset by a person shall be computed in accordance with the following formula, namely:-
A - B: where A is the consideration received by the person on disposal of the asset; and B is the cost of the asset."
"38. Deduction of losses in computing the amount chargeable under the head "Capital Gains".- (1) Subject to this Ordinance, in computing the amount of a person chargeable to tax under the head "Capital Gains" for a tax year, a deduction shall be allowed for any loss on the disposal of a capital asset by the person in the year.
(2) No loss shall be deducted under this section on the disposal of a capital asset where a gain on the disposal of such asset would not be chargeable to tax.
(3) The loss arising on the disposal of a capital asset by a person shall be computed in accordance with the following formula, namely:-
A - B: where A is the cost of the asset; and B is the consideration received by the person on disposal of the asset.
(4) The provisions of sub-section (4) of section 37 shall apply in determining component A of the formula in sub-section (3).
(5) No loss shall be recognised under this Ordinance on the disposal of the following capital assets, namely:-
(a) A painting, sculpture, drawing or other work of art;
(b) jewellery;
(c) a rare manuscript, folio or book;
(d) a postage stamp or first day cover;
(e) a coin or medallion; or
(f) an antique."
The allowances, expenses and deductions with respect to income from business are governed by sections 20, 22 to 31.
Broadly speaking all kinds of expenses and allowances are deductible if they are of revenue nature and are incurred in deriving income chargeable under the head 'Income from Business' [section 18].
FORWARD TRANSACTIONS ON THE STOCK EXCHANGE: In forward business at the stock exchange, the purchase and sale are made in advance based on the parties' estimate as to what the price will be of particular scrip on a specified future date.
The transactions have the nature of futures contracts (called "speculation business" under the Ordinance) and the contracting parties generally do not take actual delivery of scrip but settle the difference in price on the agreed date.
Actual delivery can, however, be enforced on the registered stock exchanges of Pakistan (at Karachi, Lahore, and Islamabad), as their rules do not permit "speculation".
The CBR is of the opinion that profit or loss on forward transactions constitutes "speculation business" as defined in section 19(2). A question arises as to whether a loss sustained by a taxpayer from a forward contract will be a business loss or a loss under the "capital gains" heading.
Since the law provides that profits of such business are to be charged as capital gains, it is logical to conclude that any loss arising from a forward contract will be treated as a loss under the head "Capital Gains".
This view was upheld by the Income Tax Appellate Tribunal in 1998 and therefore the CBR Circular should be ignored as expressing a contrary view.
TAXATION OF FUTURES CONTRACTS AS SPECULATION BUSINESS INCOME: The most important aspect of the taxation of futures contracts and other like financial instruments under the income tax law is that income therefrom is treated as income of a distinct heading (ie a sub-heading under the "income from business" heading). Section 19(1) states:
"(1) Where a person carries on a speculation business-
(a) that business shall be treated as distinct and separate from any other business carried on by the person;
(b) this Part shall apply separately to the speculation business and the other business of the person;
(c) section 67 shall apply as if the profits and gains arising from a speculation business were a separate head of income;
(d) any profits and gains arising from the speculation business for a tax year computed in accordance with this Part shall be included in the person's income chargeable to tax under the head "Income from Business" for that year; and
(e) any loss of the person arising from the speculation business sustained for a tax year computed in accordance with this Part shall be dealt with under section 58."
The taxation of futures contracts, if these constitute business, will be under the distinct heading of "speculation business". The definition of "speculation business" is provided in the section 19(2):
"(2) In this section, "speculation business" means any business in which a contract for the purchase and sale of any commodity (including stock and shares) is periodically or ultimately settled otherwise than by the actual delivery or transfer of the commodity, but does not include a business in which-
(a) a contract in respect of raw materials or merchandise is entered into by a person in the course of a manufacturing or mercantile business to guard against loss through future price fluctuations for the purpose of fulfilling the person's other contracts for the actual delivery of the goods to be manufactured or merchandise to be sold;
(b) a contract in respect of stocks and shares is entered into by a dealer or investor therein to guard against loss in the person's holding of stocks and shares through price fluctuations; or
(c) a contract is entered into by a member of a forward market or stock exchange in the course of any transaction in the nature of jobbing arbitrate to guard against any loss which may arise in the ordinary course of the person's business as such member."
This definition includes futures contracts. A transaction constituting a purchase and sale of anything other than stock, shares, or commodities would not be a speculative transaction under this provision; in any case, where actual delivery or transfer of the commodity or scrip takes place, the transaction cannot be regarded as a speculative transaction, even if it is highly speculative in nature.
In addition, compensation received for the breach of a sales contract is not receipt from a speculative transaction.
In fact, the latter will not true of a "settled" contract, which is a requirement of the above section.
Besides, certain transactions (e.g. hedging contracts entered into by manufacturers and merchants in the course of business to guard against loss from future price fluctuations) are excluded from the definition of "speculative transactions" in section 19(2).
The burden of proving that the transactions are hedging transactions is on the taxpayer.
DEDUCTIBILITY AND SET-OFF OF LOSSES: Under section 58, a loss in a speculation business, unlike other losses, cannot be set off against any income under the same heading (ie business or profession), nor, according to section 57, can it be set off against income under any other heading; however, it can be set off only against profits, if any, of another speculation business (section 19).
Losses from a speculation business cannot be set off even against the profits of the same business of which the speculation actually forms a part, because speculation is deemed, by a legal fiction, to be distinct and separate from any other business (section 19).
Thus, commissions earned by a broker for carrying out speculative transactions on behalf of his clients are not income from speculation business, even if the broker carries on speculation business on his own account.
If a liability of the taxpayer had been originally allowed in computing the profits or loss of a speculation business, when that liability is subsequently remitted it should be assessed as income under section 19(1) from the speculation business.
A taxpayer who incurs a loss in a speculation business carried on by him individually is entitled to set it off against his share of the profits in another speculation business carried on by a firm in which he is a partner.
Under section 58, losses from a speculation business can be carried forward to a subsequent year and set off only against the profits of any speculation business carried on in that year, even if the profits are of a speculation business distinct and separate from the speculation business in which the loss had been incurred, and even if that speculation business in which the loss had been incurred was discontinued prior to such subsequent year.
Like other business losses under section 52, losses from a speculation business under this section can be carried forward only for a period of six years.
Although the taxation of derivative is highly complex and intricate, the relevant provisions indicate certain features as the key points of the tax regime.
Taxpayers are not entitled to deduct all the expenses which can normally be claimed under the business heading.
In addition, these transactions are to be treated separate from all other business activities.
As a result, any loss arising out of such transactions cannot be claimed or set off against any other source of income or any other speculative transaction (with the exception provided by section 58).