Derivatives Vs Shares: Tax Clarity On The Horizon

The Indian financial markets have witnessed unprecedented growth in derivative trading over the past decade, with retail participation reaching historic levels. This surge has brought derivatives vs shares taxation in India into sharp focus, particularly as recent legislative and regulatory changes have sought to bring clarity to what has long been a complex area of tax law. Understanding the distinction between how derivatives and shares are taxed is no longer just an academic exercise but a practical necessity for millions of Indian investors navigating these markets.

The Fundamental Tax Classification under Derivatives vs Shares Taxation in India

The most critical distinction in understanding the taxation of derivatives vs shares lies in how income from each is classified under the Income Tax Act, 1961. This classification determines not just the applicable tax rate but also the manner in which losses can be set off, the audit requirements, and the overall compliance burden on the taxpayer.

Income from trading in derivatives, which include futures and options contracts on recognized stock exchanges, is classified as business income. This classification stems from the very nature of derivative transactions, where typically no actual delivery of the underlying asset takes place. The Income Tax Act recognizes this through its definition and treatment of such transactions.

In contrast, income from the sale of shares held as investments is taxed under the head of capital gains. The holding period of the shares determines whether the gains are short-term or long-term, with different tax rates applying to each category. For listed equity shares, gains from shares held for more than twelve months qualify as long-term capital gains, while those held for shorter periods are classified as short-term capital gains.

Section 43(5) and the Non-Speculative Business Income Classification

The cornerstone of derivative taxation in India is found in the proviso to Section 43(5) of the Income Tax Act, 1961. This provision was amended by the Finance Act, 2005, to specifically exclude eligible transactions in respect of trading in derivatives of securities carried out on a recognized stock exchange from the definition of speculative transactions. The section reads: “an eligible transaction in respect of trading in derivatives referred to in clause (ac) of section 2 of the Securities Contracts (Regulation) Act, 1956 carried out in a recognized stock exchange shall not be deemed to be a speculative transaction.”

This amendment was a watershed moment for derivative traders. Prior to this change, all transactions settled otherwise than by actual delivery were treated as speculative transactions, which severely limited the ability of traders to set off losses against other business income. The amendment recognized the legitimate nature of derivative trading on organized exchanges and brought it within the fold of non-speculative business income [1].

The practical implication of this classification is that profits and losses from futures and options trading are treated as business income and can be set off against profits from any other business or profession. This represents a significant advantage over the earlier regime where such losses could only be set off against profits from other speculative transactions.

Judicial Interpretation: The Snowtex Investment Case

The Supreme Court of India provided definitive clarity on the treatment of derivative losses in the landmark case of Snowtex Investment Limited v. Principal Commissioner of Income Tax, Central-2, Kolkata (2019) [2]. The Court held that once the provisions of Section 43(5), as amended by the Finance Act of 2005, came to treat a trade in derivatives as not a speculative transaction when carried out on a recognized stock exchange, the effect of that amendment was to treat transactions in derivatives as merely business transactions. Consequently, the Court ruled that losses in derivative business would be business losses for the purposes of Section 72 of the Income Tax Act, and set-off of such business losses must be permitted against profits and gains of business.

This judgment resolved a long-standing controversy where revenue authorities had attempted to deny the set-off of derivative losses by invoking the explanation to Section 73 of the Income Tax Act. The Supreme Court’s ruling made it clear that the legislative intent behind amending Section 43(5) was to provide relief to derivative traders and allow them the full benefit of business loss set-off provisions.

The Bombay High Court further reinforced this position in various decisions, holding that transactions in respect of trading in derivatives carried out in a recognized stock exchange are excluded from the definition of speculation transaction under Section 43(5) of the Income Tax Act [3]. These judicial pronouncements have created a stable and predictable tax environment for derivative trading in India.

Capital Gains Taxation Framework for Shares

The taxation of gains from equity shares follows an entirely different framework based on the capital gains provisions of the Income Tax Act. The Union Budget 2024 introduced significant reforms to this framework, seeking to rationalize and simplify the capital gains tax regime that had become complex over the years.

For listed equity shares on which Securities Transaction Tax has been paid, short-term capital gains arising from shares held for twelve months or less are now taxed at a flat rate of twenty percent under Section 111A of the Income Tax Act [4]. This represents an increase from the earlier rate of fifteen percent, reflecting the government’s intent to moderate speculative activity in the equity markets.

Long-term capital gains on listed equity shares, arising from shares held for more than twelve months, are taxed at 12.5 percent under Section 112A of the Income Tax Act [4]. The Budget 2024 increased the exemption limit for such gains from one lakh rupees to 1.25 lakh rupees per financial year. This means that long-term capital gains up to this threshold remain completely exempt from tax, providing relief to small and medium investors.

A crucial change brought about by Budget 2024 was the removal of indexation benefits for computing capital gains on most assets transferred on or after July 23, 2024. While this simplifies computation, it has implications for the effective tax burden, particularly on assets held for extended periods where inflation adjustment would have significantly reduced the taxable gain.

The Regulatory Framework: SEBI’s Role in Derivative Markets

The Securities and Exchange Board of India, established under the Securities and Exchange Board of India Act, 1992, serves as the primary regulator for derivative and equity markets in India. SEBI’s regulatory framework is built on the foundation of the Securities Contracts (Regulation) Act, 1956, which provides the legal basis for recognizing stock exchanges and regulating contracts in securities, including derivatives [5].

SEBI has taken unprecedented steps in recent years to address concerns about excessive speculation in the derivatives market, particularly among retail investors. The October 2024 circular on measures to strengthen the equity index derivatives framework marked a significant regulatory intervention aimed at increased investor protection and market stability [6].

These measures, which took effect in November 2024, included increasing the minimum contract size for index derivatives from the earlier range of five to ten lakh rupees to fifteen to twenty lakh rupees. This increase was designed to reduce excessive participation from retail investors who may not have the financial capacity or risk understanding to engage in such trading.

SEBI also rationalized weekly expiry products, limiting each exchange to offering weekly expiry contracts for only one of its benchmark indices. Previously, multiple indices had weekly expiries, which critics argued contributed to excessive speculation and volatility, particularly on expiry days. The National Stock Exchange retained weekly expiries for the Nifty index on Thursdays, while the BSE maintained them for the Sensex on Fridays.

Additional measures included the introduction of an Extreme Loss Margin of two percent on all open short options positions on expiry day, effective from the same date. This measure addresses the heightened risk and volatility typically observed on expiry days. From February 2025, option buyers were required to pay premiums upfront, eliminating the ability to carry leveraged positions without adequate collateral. Intraday monitoring of position limits, which commenced from April 2025, represented another layer of oversight to prevent traders from exploiting loopholes.

Securities Transaction Tax and the Budget 2024 Changes

Securities Transaction Tax represents an additional layer of taxation applicable to both derivative and equity share transactions. However, the rates and manner of application differ significantly between the two categories.

For delivery-based equity transactions, STT is levied at 0.1 percent on both purchase and sale. For equity derivatives, the Budget 2024 made substantial changes effective from October 1, 2024. The STT rate on the sale of options in securities increased from 0.0625 percent to 0.1 percent of the option premium [7]. Similarly, the STT on sale of futures in securities doubled from 0.0125 percent to 0.02 percent of the price at which such futures are traded [7].

These increases in STT rates were explicitly aimed at curbing excessive speculation in derivatives markets. The impact was immediate and substantial, with market participants reporting a reduction in market liquidity by thirty to forty percent in the months following implementation. This demonstrates the government’s willingness to use tax measures as a tool for market regulation and investor protection, even at the cost of some reduction in market activity.

Turnover Computation and Audit Requirements

The method of computing turnover for derivative trading differs fundamentally from equity trading and has significant implications for tax audit requirements. For futures and options trading, turnover is computed as the absolute sum of both positive and negative differences, not the contract values. This means that if a trader earns a profit of eighty thousand rupees on one contract and incurs a loss of fifty thousand rupees on another, the turnover for audit purposes would be computed as one lakh thirty thousand rupees, not the total contract value which could run into lakhs or crores.

Under Section 44AB of the Income Tax Act, a tax audit is mandatory if business turnover exceeds one crore rupees. The audit is also required in cases where turnover is between one crore and two crore rupees but profits are less than eight percent of turnover for digital transactions or six percent for other transactions, provided the total income exceeds the basic exemption limit. For derivative traders, even those with relatively modest actual profits or losses, the turnover can quickly exceed these thresholds, triggering audit requirements.

In contrast, for equity shares held as investments, no turnover computation applies as the income is classified as capital gains, not business income. This represents a significant compliance advantage for equity investors compared to active derivative traders.

Set-Off and Carry Forward of Losses

The rules for setting off and carrying forward losses represent one of the most practically significant differences between derivative and equity taxation. Losses from derivative trading, being non-speculative business losses, can be set off against profits from any business or profession in the same year. If losses cannot be fully absorbed in the year of occurrence, they can be carried forward for eight assessment years and set off against business profits in those years.

However, this carry forward benefit is available only if the income tax return is filed within the due date specified under Section 139(1) of the Income Tax Act. This is typically July 31st of the assessment year for individuals not required to get their accounts audited, and September 30th for those subject to audit requirements. Late filing results in the permanent loss of the ability to carry forward business losses, though current year set-off is still permissible.

For equity shares, short-term capital losses can be set off against both short-term and long-term capital gains in the same year. Long-term capital losses can be set off only against long-term capital gains, not against short-term gains. If capital losses cannot be fully absorbed in the year of occurrence, they can be carried forward for eight assessment years. However, unlike business losses, the carry forward of capital losses also requires timely filing of the return.

The ability to set off losses across different categories represents a key advantage of the business income classification for derivatives. A derivative trader who also has income from salary or other business can reduce their overall tax liability by setting off derivative losses against such income. In contrast, capital losses from shares can only be set off against capital gains, not against salary or business income.

Recent Developments and Future Outlook

The taxation landscape for derivatives and shares continues to evolve in response to market developments and policy objectives. The Finance Act, 2025 has maintained the capital gains tax rates introduced in Budget 2024, indicating that the government considers the current structure appropriate for achieving its twin objectives of revenue collection and market regulation.

SEBI’s study released in July 2025, analyzing data from the financial year 2024-25, revealed that approximately ninety-one percent of retail traders in the equity derivatives segment ended up with net losses [8]. The collective losses widened by forty-one percent to 1.05 trillion rupees compared to the previous year. These findings have intensified the regulatory focus on retail participation in derivatives and may lead to further tightening of norms.

The government and SEBI appear committed to ensuring that derivative markets serve their intended purpose of price discovery and risk management rather than becoming avenues for uninformed speculation. The taxation framework, combined with regulatory measures such as increased contract sizes and rationalized expiry structures, represents a multi-pronged approach to achieving this objective.

For investors and traders, the message is clear: understanding the tax implications of derivative versus equity investing is not optional but essential. The classification of income, the applicable tax rates, the audit requirements, and the loss set-off provisions all differ fundamentally between these two categories. Making informed decisions requires not just market knowledge but also tax awareness.

Practical Implications for Investors

The choice between investing in shares or trading in derivatives should factor in not just market views and risk appetite but also tax efficiency. An investor primarily focused on long-term wealth creation through equity markets may find the capital gains framework more favorable, with its exemption threshold and relatively moderate long-term capital gains tax rate of 12.5 percent.

On the other hand, an active trader who frequently enters and exits positions might find themselves subject to the higher short-term capital gains tax rate of twenty percent if trading in shares. Such traders might benefit from a clear classification of their activity as business income, allowing them to claim business expenses such as internet charges, software costs, advisory fees, and a proportionate share of other business infrastructure costs.

The transparency and clarity that has emerged from legislative amendments and judicial pronouncements have created a more predictable environment for tax planning. The days when the classification of derivative income was uncertain and subject to varying interpretations by tax authorities are largely behind us. The legal position is now well-settled: derivatives traded on recognized exchanges are non-speculative business income, entitled to the full benefits of business loss set-off.

However, this clarity also brings with it increased compliance obligations. Derivative traders must maintain proper books of account, prepare profit and loss statements and balance sheets, and potentially undergo tax audits. They must also ensure timely filing of returns to preserve the benefit of loss carry-forward. These requirements demand a level of tax discipline that casual investors may find burdensome.

Conclusion

The taxation of derivatives vs shares in India has evolved from an area of uncertainty and litigation to one of relative clarity, thanks to legislative amendments, judicial pronouncements, and comprehensive regulatory frameworks. The fundamental distinction between business income for derivatives and capital gains for shares now rests on solid legal foundations, providing taxpayers with the certainty needed for informed decision-making.

The Union Budget 2024 marked a significant milestone in rationalizing the capital gains tax structure, introducing uniform rates while removing complexities such as indexation. The increase in Securities Transaction Tax rates on derivatives and the rise in short-term capital gains tax on equity shares reflect a policy orientation toward encouraging long-term investment over short-term speculation an approach that lies at the heart of derivatives vs shares taxation in India.

SEBI’s regulatory measures, particularly those implemented from November 2024 onward, complement the tax framework in shaping market participant behavior. The increase in contract sizes, rationalization of weekly expiries, and enhanced margin requirements all work in tandem with the tax structure to create a more stable and sustainable market ecosystem.

For market participants, the imperative is clear: engage with derivatives and equity markets with full awareness of the tax implications. Consult tax professionals when needed, maintain proper documentation, and ensure compliance with all applicable provisions. The era of tax uncertainty in this domain is largely over, but the responsibility for proper tax planning and compliance now rests squarely with the investor and trader.

As India’s capital markets continue their growth trajectory, the tax and regulatory frameworks governing derivatives and shares will undoubtedly continue to evolve. However, the fundamental principles established through legislation and reinforced by judicial interpretation provide a stable foundation. The future promises not just clarity on the horizon, but clarity already achieved, waiting to be understood and applied by those who engage with these markets.

References

[1] Income Tax Act, 1961, Section 43(5), Proviso clause (d). Available at: https://www.indiacode.nic.in/handle/123456789/1362 

[2] Snowtex Investment Limited v. Principal Commissioner of Income Tax, Central-2, Kolkata, 2019 SCC OnLine SC 749. Available at: https://taxtorium.com/souvenir-developers-i-pvt-ltd-vs-the-union-of-india/ 

[3] LiveLaw, “Loss On Trading In Derivatives Of Securities Not A Speculative Loss, Can Be Set Off Against Business Income: Bombay High Court,” May 23, 2022. Available at: https://www.livelaw.in/news-updates/bombay-high-court-income-tax-act-itat-finance-act-assessing-officer-ao-199490 

[4] Press Information Bureau, Government of India, “FAQs issued by CBDT on the new capital gains tax regime proposed in the Union Budget 2024-25,” 2024. Available at: https://www.pib.gov.in/PressReleaseIframePage.aspx?PRID=2036604 

[5] Securities Contracts (Regulation) Act, 1956, Section 2. Available at: https://www.sebi.gov.in/acts/contractact.pdf 

[6] Securities and Exchange Board of India, “Measures to Strengthen Equity Index Derivatives Framework for Increased Investor Protection and Market Stability,” Circular, October 2024. Available at: https://www.sebi.gov.in/legal/circulars/oct-2024/measures-to-strengthen-equity-index-derivatives-framework-for-increased-investor-protection-and-market-stability_87208.html 

[7] Lexology, “India’s Budget 2024-25 – Key Highlights,” July 23, 2024. Available at: https://www.lexology.com/library/detail.aspx?g=ec0db524-8b9d-4bd3-a165-af9f92385c2f 

[8] National Institute of Securities Markets, “Retail Derivatives Trading in India: SEBI’s Alarming Findings and Regulatory Measures,” August 8, 2025. Available at: https://www.nism.ac.in/equity-linked-exchange-traded-derivative-contracts-the-retail-rush-and-regulatory-measures/ 

[9] Zerodha Varsity, “Taxation for Traders,” July 29, 2025. Available at: https://zerodha.com/varsity/chapter/taxation-for-traders/