The changes in taxation of transactions in futures on equity and commodity underlyings

Taxation of transactions in India began with the equity market in
2004. Prior to 2008, the securities transaction tax (STT) was allowed
as a rebate against tax liability against Section 88E of the Income
Tax Act. This treatment was withdrawn by the 2008 Budget
announcement. After that, STT became a substantial influence on the
equity market. In understanding the consequences of the STT, there is
an absolute perspective and there is a relative perspective.

In absolute terms, suppose you embark on a spot-futures arbitrage
and do an early unwind. In this, you buy shares (pay 10), sell futures
(1.7) and then reverse yourself (10). Your tax burden is 21.7 basis
points. This is a lot of money when compared with the typical
bid-offer spread of the Nifty futures which is around 0.5 basis
points. The dominant cost faced in doing spot-futures arbitrage is
taxation.

In relative terms, there are two issues. The first is an
intra-India comparison between equities and commodities. When activity
on the equity market was taxed, eyeballs and capital moved to
commodities trading. Commodity futures trading has grown by
3.5 times after 2008, while equities activity has
stagnated. Most policy makers think this was an undesirable effect,
particularly given the fact that India can free ride on global price
discovery for non-agricultural commodities but must foster liquid
markets in its own equities.

And then, there is an international dimension. When the activities
of non-residents in India are taxed in any fashion, they favour taking
their custom to places like Singapore, which practice `residence-based
taxation' where the tax base comprises the activities of residents
only. We got a sharp shift in equities activity towards locations
outside India.

Putting these absolute and relative perspectives together, from
2008 onwards, equity market liquidity has fared badly. This yields an
elevated cost of equity capital.

The budget speech has done two things. First, it has dropped the
STT rate on futures on equity underlyings from 1.7 basis points to 1
basis points. This is helpful for certain kinds of trading strategies
but not for others (e.g. the spot-futures arbitrage described above
will gain little). HF strategies that do not involve the spot market
will particularly benefit - e.g. imagine an options market maker who
does delta neutral hedging on the futures market. Second, it has
introduced taxation for non-agricultural commodity futures on an
identical basis to the equity futures (i.e. at 1 basis points).

This will have the following interesting implications:

1. Capital and labour in securities firms will be less inclined to
   be in non-agricultural commodity futures. It will tend to move
   towards agricultural commodity futures, currency futures and equity
   futures.
   
   
2. The comparison between offshore venues and the onshore market
   will move in favour of the onshore market for certain kinds of
   trading strategies.
   
   
3. The bias in favour of equity options will reduce; some business
   will move to equity futures.
   
   
4. The pricing efficiency of futures will go up.
   

In this environment, there seems to be a fair arrangement between
the equity futures and commodity futures. Conditions seem to be unfair
with the equity spot (too high), equity options (too low) and currency
derivatives (too low). The next moves on this may appear in July 2014
when the new government unveils its next budget.

One more announcement of the budget speech concerns currency
futures: it was stated that FII activity on currency futures will
commence. This will also give more activity on currency futures; we
now have two reasons for expecting more activity on currency futures
(the taxation of commodity futures and the entry of FII order
flow). However, the shifting of FII order flow will be a slow process,
and a lot of time will be lost on their due diligence of the exchange,
safety of the clearinghouse, and so on. While, in the long run,
removing capital controls against FII order flow in India is a good
thing, it is not an effect that will kick in quickly. Apart from this,
most of the action will take place fairly quickly, in early April.

Future finance ministers will need to navigate the difficult
landscape of gradually scaling down taxation of transactions while
retaining low taxation of capital gains (which has unfortunately come
to be seen as a linked issue in the Indian discourse). Along this
path, the first priority should be to remove distortions. Our first
priority should be to achieve a low rate, a wide base, and the minimal
distortions. Reduced rates will always yield welfare gains. The Budget
2013 announcement makes progress on two things (reduction from 1.7 to
1, and reduced distortions between equities and non-agricultural
commodities). There is much more waiting to be done: integrating
currencies and fixed income, bringing sense to options, and getting
away from the very high rates on the equity spot market.