Currency Derivatives - Taxation, Accounting & Regulatory framework - Chapter 7

An important aspect of derivatives is the accounting part of it and all futures have been classified as securities under the Securities Contracts Regulation Act (SCRA). To that extent exchange traded currency futures and options will also be classified as securities for the purpose of accounting and taxation as well as the regulatory and self-regulatory environment.

Accounting For Currency Derivatives Transactions

ICAI has issued guidance notes on accounting of index futures contracts from the view point of parties who enter into such futures contracts as buyers or sellers. For trading members, a trade in currency futures is similar to a trade in, say shares, and does not pose any accounting challenge.

How clients must account for currency derivative transactions

Any client transacting in the currency futures market is required to maintain two separate accounting heads for initial margin (currency futures account) and mark to market margin (currency futures account). These heads could be called as:

• Initial margin‐currency futures
• Mark to market‐ currency futures

Any additional deposit with trading member can be placed instead of settling it on a daily basis. Such account can be termed “Deposit for mark to market margin account”.

Accounting entries for live transactions: pay-ins and pay-outs

We shall first focus on open positions that are live and how they must be accounted for in the event of pay-outs and pay-ins separately.

• In case of pay out, any cash outlay for initial margin or mark to market (MTM) must be debited to respective heads as explained above. On the balance sheet date, any debit balance in “Initial margin-currency futures” or “MTM” account is shown as current assets in the balance sheet. In case client has given bank guarantees instead of cash, a disclosure should be made in the notes to accounts.
• In case of pay-in, any cash inflow on account of MTM settlement will be credited to the MTM-Currency Futures account. On the balance sheet date, credit balance in “Mark to market‐ currency futures” will be shown under the current liability header.

Accounting entries for expired or cancelled transactions

At the expiry of a series of currency futures, the profit/loss is calculated as the difference between final settlement price and the contract price for each contract in the series and is either credited or debited to the P&L account. A provision account can be created for any anticipated loss arising on final settlement. In case of multiple contracts, the FIFO method is used to calculate profits / losses.

Accounting entries in the event of default by clients

When a client defaults in on paying up for the daily settlement, the contract is closed out. The amount not paid by the client is adjusted against the initial margin. In the books of client, the amount so adjusted should be debited to “Mark to market-currency futures account” with a corresponding credit to “Initial margin-currency futures account”. In case, the amount to be paid on daily settlement exceeds the initial margin the excess is a liability and should be shown under the head “current liabilities and provisions” in the balance sheet. Any profits or losses are either credited or debited to the P&L account.

An important point to remember in accounting is that when margins are given in securities or in bank guarantee form, there is no accounting entry. However, such an item must be mentioned under the Notes to Accounts for reference.

How are currency derivatives transactions taxed?

Prior to the year 2005, there was a debate on whether the futures and options transactions should be classified as speculative transactions for the purpose of tax. However, in 2005, the CBDT (Central Board of Direct Taxes) clarified that any derivative transaction classified as a security under the SCRA and listed and traded on a recognized stock exchange shall be treated as non-speculative transaction for taxation purposes.

Prior to the clarification issued in 2005, the determining legislation was Section 43(5) of the Income Tax Act which defined speculative transaction as a transaction in which a contract for purchase or sale of any commodity, stocks and shares, was ultimately settled otherwise than by actual delivery. However, derivative contracts entered into by hedgers and stock exchange members in course of jobbing or arbitrage activity were specifically excluded from the purview of “speculative transaction”.

Since this was extremely ambiguous and hard to track and monitor, the Finance Act, 2005 amended Section 43(5) to exclude transactions in derivatives carried out on a “recognized stock exchange” from the purview of speculative transaction. Therefore, income or loss on derivative transactions which are carried out in a “recognized stock exchange” is not taxed as speculative income or loss. Thus, loss on derivative transactions can be set off against any other income during the year (except salary income). In case the same cannot be set off, it can be carried forward to subsequent assessment year and set off against any other non-speculative business income of the subsequent year. Such losses can be carried forward for a period of 8 assessment years.

Regulatory Framework Governing Currency Derivatives

Regulation of currency derivatives happens at multiple levels. While the commencement of currency futures trading was guided by the recommendations of the Committee on Fuller Capital Account Convertibility, there are a variety of acts and rules that govern the trading of currency derivatives.

• Since exchange traded currency derivatives are classified as securities under the SCRA, the SCRA 1956 and modified in 2013 is used as the primary regulatory guide for trading in exchange traded currency futures.
• Currency trading is also regulated by SEBI Act since they are classified as securities and are therefore governed by the SEBI regulations on trading in exchanges, risk management, market integrity etc.
• RBI also becomes a regulator since the trades in currency futures and options have an impact on the value of currency which comes under the direct purview of the RBI.
• The Foreign Exchange Management Act (FEMA) is another guiding act that regulates transactions in currency futures and options.

The Reserve Bank of India vide its circular dated December 10, 2015 specified the guidelines for the introduction of currency futures contracts on cross-currency pairs of EURUSD, GBPUSD and USDJPY on recognized stock exchanges. In the same circular, RBI has also allowed recognized stock exchanges to offer exchange traded currency options contracts on EURINR, GBPINR and JPYINR currency pairs (in addition to the existing USDINR options contract). Subsequently, SEBI vide its circular dated March 9, 2016 allowed trading in the above cross currency derivatives contracts and has specified the product design and risk management framework. That is broadly how the regulation flow works.

Eligibility Criteria For Members In Currency Derivatives Segment

While individuals and partnerships are also allowed to become members of the currency derivatives market (CDM), a vast majority of the significant players are corporates. Let us look at the eligibility criteria of corporates to become CDM members.

1. Any company registered under the Companies Act 1956 and formed in accordance with the provisions of Section 12 is eligible to be admitted as a member of the CDM.
    
2. The company must comply with such financial requirements and norms as may be specified by SEBI from time to time.
    
3. The directors of the company must not be disqualified from being members of a stock exchange and the directors must not have held the position of director in any company that was declared defaulter by the stock exchange or expelled.
    
4. It fulfils all other criteria which may be specific to each individual exchange and subject to modifications from time to time.
5.  

CDM Broker Code Of Conduct To Protect Investor Interest

The broker code is largely in line with the code of conduct in the equity and equity derivatives segment so we shall highlight the key points. A registered CDM broker must abide by the Code of Conduct as under at all times. Here are the highlights.

• A CDM broker must maintain high standards of integrity and fairness in the conduct of all his business. In addition, the broker should act with due skill, care and diligence in the conduct of business.
• The CDM broker must not indulge in manipulative or fraudulent practices nor deliberately spread rumours to distort market equilibrium for personal gains. They must also desist from false and concerted circular market creation.
• The CDM broker must abide by all the provisions of the relevant statutory acts as well as the rules, regulations issued by the Government, SEBI and the stock exchanges from time to time including specific RBI circulars.
• In his dealings with the clients the CDM broker must ensure best market price and inform client about the execution. Additionally, contract notes must be issued on time at the end of each trading day as well as the ledger on a periodic basis.
• The CDM broker must never make improper use of the details of personal investments of clients and other information of a confidential nature for their own profits or for the profits of a preferred group of customers.
• CDM brokers must educate customers to avoid mis-selling just to earn commissions. They should not give false or misleading advice or information to the clients with a view of inducing them to do business. Assuring returns is strictly prohibited.
• A broker should not deal or transact business knowingly, directly or indirectly or execute an order for a client who has failed to carry out his commitments in relation to securities with another broker. Defaulting clients are to be avoided.
• A broker should not make any recommendation to any client unless they have reasonable grounds to believe that the recommendation is suitable for such a client upon the basis of details disclosed by such a client.
• Any front running of contracts before the advice is given by the CDM broker or any of the employees / analysts is strictly prohibited. It is a punishable offence and entails serious penalties on the employee and the broker.
• All trades should be only entered directly in the UCC of the customer and no error transfers of transactions should be done. The CDM broker is not authorized to place trades in any UCC without a specific order given by the client.
• CDM broker and employees are barred from shielding any employee who has breached the rules. Also, business shall not be transacted by the Trading Member in derivatives contracts which have been suspended from official quotation.
• The CDM broker shall not make bids/offers for derivatives contracts with an intention of creating a false or misleading appearance with respect to the market demand for, or the price of any derivatives contracts. This amounts to front running.