TAXATION OF DERIVATIVES
By Syed Muhammad Ijaz, FCA, LL.B
Under the Income Tax Ordinance, 2001 and the rules made there under no
specific provisions are given dealing with the taxation of derivatives or derivative
instruments. Taxation of derivates is quite a neglected subject in Pakistan. So far
as accounting is concerned IAS 39 (Financial Instruments: Recognition and
Measurement) deals with the measurement and recognition of derivatives
whereas IAS 32 deals with presentation.
IAS 391 defines derivatives in para 9 as;
A Derivative is a financial instrument:
• Whose value changes in response to the change in an underlying variable
such as an interest rate, commodity or security price, or index;
• That requires no initial investment, or one that is smaller than would be
required for a contract with similar response to changes in market factors;
• That is settled at a future date.
Examples of Derivatives2;
Forwards3: Contracts to purchase or sell a specific quantity of a financial
instrument, a commodity, or a foreign currency at a specified price determined at
the outset, with delivery or settlement at a specified future date. Settlement is at
maturity by actual delivery of the item specified in the contract, or by a net cash
Interest Rate Swaps and Forward Rate Agreements4: Contracts to exchange
cash flows as of a specified date or a series of specified dates based on a
notional amount and fixed and floating rates.
Futures5: Contracts similar to forwards but with the following differences: futures
are generic exchange-traded, whereas forwards are individually tailored. Futures
are generally settled through an offsetting (reversing) trade, whereas forwards
are generally settled by delivery of the underlying item or cash settlement.
Options6: Contracts that give the purchaser the right, but not the obligation, to
buy (call option) or sell (put option) a specified quantity of a particular financial
IAS 39 Financial Instruments: Measurement and Recognition
instrument, commodity, or foreign currency, at a specified price (strike price),
during or at a specified period of time. These can be individually written or
exchange-traded. The purchaser of the option pays the seller (writer) of the
option a fee (premium) to compensate the seller for the risk of payments under
Caps and Floors7: These are contracts sometimes referred to as interest rate
options. An interest rate cap will compensate the purchaser of the cap if interest
rates rise above a predetermined rate (strike rate) while an interest rate floor will
compensate the purchaser if rates fall below a predetermined rate.
Contracts with Embedded Derivatives8: Some contracts that themselves are
not financial instruments may nonetheless have financial instruments embedded
in them. For example, a contract to purchase a commodity at a fixed price for
delivery at a future date has embedded in it a derivative that is indexed to the
price of the commodity.
An embedded derivative is a feature within a contract, such that the cash flows
associated with that feature behave in a similar fashion to a stand-alone
derivative. In the same way that derivatives must be accounted for at fair value
on the balance sheet with changes recognized in the income statement, so must
some embedded derivatives. IAS 39 requires that an embedded derivative be
separated from its host contract and accounted for as a derivative when: [IAS
• the economic risks and characteristics of the embedded derivative are not
closely related to those of the host contract
• a separate instrument with the same terms as the embedded derivative
would meet the definition of a derivative, and
• the entire instrument is not measured at fair value with changes in fair
value recognized in the income statement
If an embedded derivative is separated, the host contract is accounted for under
the appropriate standard (for instance, under IAS 39 if the host is a financial
instrument). Appendix A to IAS 39 provides examples of embedded derivatives
that are closely related to their hosts, and of those that are not.
Examples of embedded derivatives that are not closely related to their hosts (and
therefore must be separately accounted for) include:
• the equity conversion option in debt convertible to ordinary shares (from
the perspective of the holder only) [IAS 39.AG30(f)]
• commodity indexed interest or principal payments in host debt
• cap and floor options in host debt contracts that are in-the-money when
the instrument was issued [IAS 39.AG33(b)]
• leveraged inflation adjustments to lease payments [IAS 39.AG33(f)]
• currency derivatives in purchase or sale contracts for non-financial items
where the foreign currency is not that of either counterparty to the
contract, is not the currency in which the related good or service is
routinely denominated in commercial transactions around the world, and is
not the currency that is commonly used in such contracts in the economic
environment in which the transaction takes place. [IAS 39.AG33(d)]
If IAS 39 requires that an embedded derivative be separated from its host
contract, but the entity is unable to measure the embedded derivative separately,
the entire combined contract must be designated as a financial asset as at fair
value through profit or loss). [IAS 39.12]
TAXATION OF DERIVATIVES
As stated earlier the Income Tax Ordinance and the Rules made there under
have not dealt with the issue of derivatives specifically. Provisions dealing with
the speculation business still can, to some extent, handle the taxation of
derivates yet they are incapable to deal with complex transactions.
Under Section 2(61) read with section 19 “speculation business” means any
business in which a contract for the purchase and sale of any commodity
(including 1[stocks] 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 2[arbitrage] to guard
against any loss which may arise in the ordinary course of the person’s business
as such member.
• Section 71 defines any amount taken in account must be in rupees
converted at the SBP rates prevailing on the date the amount was taken in
• Income from speculation shall be treated as a distinct and separate
• Section 67 defines that expenses where attributable to various heads of
income shall be apportioned
• Federal Board of revenue by using power u/s 237 has issued Income Tax
Rules 2002 wherein rule 13 is for apportionment of expenses.
• Under section 103 for tax credit even the speculation income has to be
treated separately. Section 104 defines that incase of foreign losses
section 67 shall apply for apportionment of expenses.
Speculation losses can only be setoff against speculation income and that only
for 6 years max immediately succeeding the tax year in which the loss first arise.
IAS 39 VS. SPECULATION BUSINESS
Forwards vs. section 19
As per IAS the forwards are the settled through actual delivery or by payment
through cash where section 19 applies to any type of commodities which are
settled otherwise than actual delivery or transfer.
Section 19 further excludes contract entered incase of goods manufactured or
merchandizes from future price fluctuations.
Interest Rate Swaps or Forward Rate Swaps vs. section 19
Cash flows are exchanged as per IAS under these cases whereas u/s 19 cash
flows cannot be categorized as commodity, stock or shares.
Futures vs. section 19
The only difference between forwards and futures is the settlement which in case
of forwards is by way of actual delivery or cash payment where in case of futures
it is by way of offsetting which duly falls within the ambit of section 19 being
settlement without delivery. Again certain exclusions are given under the
definition of speculation business in section 19.
Options vs. section 19
Section 19 only covers commodities, stocks and shares which are not defined
with reference to this section. Further section 19 does not cover the rights of buy
and sell it covers as stated earlier only commodity, stocks and shares.
Caps and Floors vs. section 19
Just like an option, some times called interest rate options. As stated earlier
options are outside the ambit of section 19
Any realized exchange gain or loss as a result of foreign currency translation
exposure is taxable being the part of the consideration. Notional gains are not
With the development of financial management complex tools/instruments are
developed and it is an ongoing process. Derivatives are closely being watched by
the taxation authorities of many countries like US. Proper rules and guidelines
shall be issued by the FBR for taxation of such instruments clearly indicating;
• When such transactions are subject to tax
• When they will be treated as capital gain
• When their nature will fall within the business income
Unless and until clear markings are made, there will remain great confusion
regarding taxation of the derivatives.
Income Tax Ordinance 2001
Income Tax Rules, 2002
IASplus by Deloitte http://www.iasplus.com/standard/ias39.htm