Crypto Derivatives - Options, Futures & Understanding Taxation

What are Crypto Derivatives?

Crypto derivatives are financial contracts that derive their value from an underlying cryptocurrency. They let traders profit from cryptocurrency price movements without owning the actual assets. In other words, crypto derivatives such as futures and options are financial instruments that allow traders to speculate on the price movements of cryptocurrencies in the future. These instruments can be used to generate profits and hedge risks. However, they also come with increased tax complications.

What is Concept of Cost Basis?

Before we go ahead and understand how crypto derivatives are taxed, it is important first to understand the concept of cost basis, as it plays a crucial role in calculating your crypto taxes.

Cost refers to the original cost or purchase price of the assets like stock, bond, or real estate property. The cost basis method helps determine the capital gain or loss on the sale or exchange of the asset.

Therefore,
Capital Gain/loss = Sale Price - Cost basis

Let’s understand this with an example. If you bought 100 shares of ABC stock at Rs.10 per share, your cost basis would be Rs.1,000. If you later sell these shares at Rs.15 per share, your total proceeds would be Rs.1,500. To calculate your capital gain, subtract your 1,000 cost basis from your Rs.1,500 proceeds, resulting in a capital gain of Rs.500.

How are Crypto Options Taxed?

Crypto options are contracts that allow buyers to buy or sell a specific cryptocurrency at a set price by a certain date. Under options, buyers have the right but are not obligated to buy or sell a cryptocurrency at a predetermined price on or before a specific date.

Buyers are not obligated to complete the transaction. These contracts can be used for speculation or hedging and can be settled in cash or the underlying cryptocurrency.

Now, the question arises, how are crypto options taxed? Their taxation depends on whether the cryptocurrencies are considered as a capital assets or not. If the options are considered

Case 1. If the options are considered to be capital assets
If the options are considered to be capital assets, then the gains or losses from the sale of such assets are known as capital gains that are subject to capital gains tax. The tax rate on long-term capital gains varies depending on the taxpayer’s income.
If there are any short-term capital gains, they will be taxed on the taxpayer’s ordinary tax slabs.

Case 2. Options are not considered capital assets
If the options are not considered to be capital assets, then any gains or losses are treated as ordinary profit and loss. This means that they will be taxed at the taxpayer’s slab rates. For example, if the taxpayer falls under the 10% slab rate, then he/she will have to pay tax on crypto gains at 10%.

What is Crypto Future Trading?

Crypto futures are derivatives contracts that make it an obligation for the buyer and seller to buy or sell a specific cryptocurrency at a predetermined price at a specified date in the future Such contracts can be used for hedging or speculation purposes and they are settled in cash. In crypto, this means agreeing to buy or sell a specific cryptocurrency at a predetermined price in the future, regardless of the market price at that time.

Hedging

Hedging with crypto futures involves protecting yourself from adverse price movements in the spot market. For example, if you own Bitcoin and expect its price to drop, you can sell Bitcoin futures contracts to lock in your profits and avoid losses.

Arbitrage

Arbitrage involves exploiting price differences between different markets or platforms. For example, if Bitcoin futures are trading at a higher price on one platform than another, you can buy low on one and sell high on the other to make a profit.

Leverage

Leverage involves using borrowed funds to amplify your returns or losses. For example, if you expect Bitcoin's price to rise, you can buy Bitcoin futures contracts using a small percentage of your own money and a significant percentage of borrowed money. This increases your exposure, potential profits, and risks.

Leverage is complex and risky, requiring knowledge, skills, and discipline. You need to understand the factors affecting cryptocurrency prices, such as supply and demand, news and events, regulations and policies, and taxation of futures and options.

How is Crypto Futures Trading Taxed in India?

The calculation of profits from crypto futures trading in India can be complicated. Exchanging Indian Rupees (INR) into USDT stablecoin to participate in crypto futures trading, does not attract any immediate tax obligations.

Capital Gains

If classified as capital gains, the tax rate depends on whether it is short-term or long-term. Crypto assets held for less than 36 months are typically considered short-term and taxed at the individual's slab rate. Long-term gains may be taxed at a lower rate.

Business Income

When you realize a profit from trading, such profit is categorized as business income. The amount of tax to be paid is determined on the basis of the conversion rate at the time of profit realization. This taxable income is then taxed at the applicable slab rates of the individual.

Profits are Taxable at a Rate of 30%

In most cases, you trade futures using USDT. When converting the total amount of USDT (including both principal and profit) back into INR, taxation is divided into two components -

Tax on the Principal Amount
The principal amount is the sum you paid to buy the initial USDT tokens invested in futures trading. The taxable gain on the principal amount is calculated based on the difference between the conversion rate and the initial purchase rate. This amount is subject to taxation at the applicable rate, plus any surcharges and cess.

Tax on the Profit Amount
The taxable gain for the profit amount (the value of additional USDT you gained) is determined based on the difference between the present conversion rate and the rate at which the profit was realized. This amount is also subject to taxation at the applicable rate and any applicable surcharges and cess.

Note: A few exchanges allow crypto futures trading in INR.

Calculation of Tax on Crypto Futures

Rahul purchased 1000 USDT at INR 85 each to start trading in futures. After a year, he earned a profit of 2000 USDT, and the price was INR 86. At the time, he decided to realize the profit, and the price rose to INR 86.5 per USDT. Here’s how crypto futures will be taxed for Rahul -

Tax on Purchase
No tax is applicable on the purchase of 1000 USDT at INR 85.

Profit of 2000 USDT
This profit is treated as business income, calculated at INR 86 per USDT, totaling INR 172,000. The tax on this amount will be based on Rahul’s applicable income tax slab rate. This amount also sets the cost basis for tax purposes.

Total Amount in INR
Here's the breakdown of the tax calculations for Rahul

On the Initial 1000 USDT (Principal):

• Taxable Gain: (INR86.5−INR85)×1000=INR1,500(INR 86.5 - INR 85) \times 1000 = INR 1,500(INR86.5−INR85)×1000=INR1,500
• Tax Payable: 30% of INR 1,500 = INR 450 (plus applicable surcharge and cess).

On the Remaining 2000 USDT (Profit):

• Taxable Gain: (INR86.5−INR86)×2000=INR1,000(INR 86.5 - INR 86) \times 2000 = INR 1,000(INR86.5−INR86)×2000=INR1,000
• Tax Payable: 30% of INR 1,000 = INR 300 (plus applicable surcharge and cess).

Tax Calculation

• Income Tax on Futures Trading Profit (INR 172,000):
  This amount is taxed according to Rahul’s applicable income tax slab rate.
• Tax on Gain from Converting USDT to INR:
  Total Tax Payable: INR 450 (on principal) + INR 300 (on profit) = INR 750 (plus applicable surcharge and cess).

TDS on Crypto Transactions

As per section 2(47A) of the Income Tax Act, crypto consists of cryptocurrencies, tokens, NFTs, etc.

Under section 115BBH, gains from cryptocurrency trading in India are taxed at 30%.

As per section 194S of the Income Tax Act, 1% TDS is applicable to cryptocurrency transactions, perpetual contracts, and transfer of VDAs. TDS is applicable to both buyers and sellers on crypto-to-crypto transactions.

TDS Thresholds

• Rs.50,000 for individuals and HUFsor specified persons whose accounts need to be audited under the Income Tax Act.
• Rs.10,000 for all other individuals who do not fall under the specified persons category

What are Perpetual Crypto Contracts?

Perpetual futures are derivative contracts that let traders speculate on the price movements of an underlying asset without owning or delivering the asset. Unlike traditional futures contracts, which have a fixed expiration date and settlement price, perpetual futures have no expiry and are continuously adjusted by a mechanism called the funding rate.

Perpetual futures are highly popular and liquid in the cryptocurrency market. The funding rate mechanism helps keep the perpetual futures price aligned with the spot price. It incentivizes traders to take positions that bring the two prices closer together. When the perpetual futures price deviates significantly from the spot price, the funding rate increases, encouraging traders to take the opposite side of the market and reduce the price discrepancy.

Features of Perpetual Contracts

Here are some features of perpetual futures contracts -

• No expiration date: Perpetual futures lack an expiration date, allowing traders to keep their positions open indefinitely without needing to close or roll over the contract.
• Funding rate: The funding rate mechanism keeps the price of perpetual futures close to the underlying asset’s spot price. Depending on the difference between the perpetual futures price and the spot price, one side of the contract pays the funding rate to the other.
• Leverage: Perpetual futures allow traders to use leverage, enabling them to control a larger position with a smaller amount of capital. Leverage can amplify both profits and losses, making risk management essential.
• Margin requirements: Traders must maintain a minimum margin balance to keep their positions open. If the balance falls below the maintenance margin requirement, the trader may face liquidation, where their position is automatically closed to prevent further loss.

What is the Difference Crypto Futures and Crypto Perpetual Futures Contracts?

A futures contract is a financial agreement between two parties to buy or sell an asset at a specific price and time in the future. These contracts are priced based on the forward-looking market price of the underlying asset, have a specific expiration date, and can be settled either physically or financially. In contrast, perpetual futures are designed to trade close to the underlying asset price, do not have an expiration date or settlement, and can be held indefinitely.

Calculating taxes on futures derivatives and understanding the various tax implications of the same can be complicated. Especially with limited knowledge with regard to crypto trading, it becomes even more difficult to manage crypto taxation.

As per the Income Tax Department, individuals trading in virtual digital assets like cryptocurrencies, crypto futures and options, crypto perpetual contracts, NFTs, etc, are required to report their income from crypto assets under schedule VDA while filing the ITR.

The last date to file ITR for FY 23-24 is 31st July 2024. Make sure you report your VDAs while filing your ITR. And, if you are still confused or need help with ITR filing, connect with our tax experts. Book online CA now!