From the above, it appears that a transaction is speculative, if it is settled otherwise than by actual delivery. The hedging and arbitrage transactions, even though not settled by actual delivery are considered non-speculative. A transaction to be speculative therefore requires that:

In the absence of a specific provision, it is apprehended that the derivatives contracts, particularly the index futures which are essentially cash-settled, may be construed as speculative transactions and therefore the losses, if any, will not be eligible for set off against other income of the assessee and will be carried forward and set off against speculative income only up to maximum of eight years.

The fact, however, is that derivative contracts are not for purchase/sale of any commodity, stock, share or scrip. Derivatives are a special class of securities under the SC(R)A, 1956 and do not any way resemble any other type of securities such as share, stocks or scrips.

Derivative contracts, particularly index futures are cash-settled, as these cannot be settled otherwise. As explained earlier, derivative contracts are entered into by hedgers, speculators and arbitrageurs. A derivative contract has any of these two parties and hence some of the derivative contracts, not all, have an element of speculation. At least one of the parties to a derivative contract is a hedger or an arbitrageur. It would, therefore, be unfair to treat derivative transactions as speculative.

Otherwise it would be a penalty on hedging which the Securities Laws (Amendment) Act, 1999 seeks to promote. In view of these difficulties in applying the existing provisions, it is desirable to clarify or make special provision for derivatives of securities.

Section 43 is relevant in case of contracts where actual delivery is possible, but these are settled otherwise than by actual delivery. This provision cannot be applied to derivatives,

particularly index futures, which can be settled only by cash. There cannot be actual delivery.

Hence the actual delivery for a contract to be non-speculative cannot be applied to derivatives contracts.

As emphasised earlier by the L.C. Gupta Committee, the futures market should have speculative appeal. This means, the speculators have to be treated equitably, that is at least

at par with hedgers, if not better. All types of participants need to be provided level playing field so that the market is competitive and efficient. As regards taxability, the law should not treat income of the hedger, speculators and arbitrageurs differently.

Income of all the participants from derivatives needs to be treated uniformly.

Further, a transaction is considered speculative, if a participant enters into a hedging transaction in scrips outside his holdings. It is possible that an investor does not have all the 30 or 50 stocks represented by the index. As a result an investor's losses or profits out of derivatives transactions, even though they are of hedging nature in real sense, it is apprehended, may be treated as speculative.

This is contrary to capital asset pricing model, which states that portfolios in any economy move in sympathy with the index although the portfolios do not necessarily contain any security in the index. The index futures are, therefore, used even for hedging the portfolio risk of non-index stocks. An investor who does not have the index stocks can also use the index futures to hedge against the market risk as all the portfolios have a correlation with the overall movement of the market (i.e. the index).

In view of the practical difficulties in administration of tax for different purposes of the same transaction, inherent nature of derivative contract requiring its settlement otherwise than by actual delivery, need to promote level playing field to all parties to derivatives contracts, and the need to promote derivatives markets, it is suggested that the exchange-traded derivatives contracts are exempted from the purview of speculative transactions.

These must, however be taxed as normal business income. This would be fiscally more prudent.

Extracted from NSE's study material on derivatives

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