Introduction
When classical mathematicians (Bhaskar Acharya, Leibniz, Issac Newton) were codifying the laws and nature of derivatives, they could not have fathomed that tax authorities one day would contend that a ‘derivative’ is the same as the underlying item, from which it derives its value.
The term ‘derivative’, by its very meaning, connotes something which is a little bit of something else[1].
In the financial world, a derivative denotes an instrument which derives its value from another instrument, for example shares, bonds, commodities, etc. The Black-Scholes model for option pricing, which is a standard model for pricing of all freely traded derivatives, contains the ‘price of the underlying asset’ as one of the components of the option pricing formula. Again, driving home the point that a derivative is different from the underlying instrument from which it derives its value.
Be that as it may, the Hon’ble Mumbai ITAT, in a recent judgement[2], was called upon to adjudicate a question as to whether a Venn Diagram of two sets of items, i.e., the meaning of derivatives as it is normally understood and its tax treatment equating it with shares thereof, would have any intersection or not.
Issue under deliberation before the Tribunal
Whether income from sale of derivatives by a Mauritius resident can be made subject to tax in India, in terms of Article 13(4) of the India-Mauritius DTAA?
Taxation of capital gains under the India-Mauritius DTAA
Section 90(2) of the Income-tax Act, 1961 (‘IT Act’) provides for the proverbial ‘treaty override[3]’, i.e., an option to the taxpayer to be either governed by the provisions of the IT Act or the applicable tax treaty, to the extent whichever would be beneficial to them.
Article 13(1), (2) and (3) of the DTAA provides for taxation of capital gains arising from alienation of immovable property situated in a source state, property forming part of a permanent establishment in a source state and gains from alienation of ships and aircraft respectively.
Article 13(3A) provides that gains from alienation of shares in a company which is a resident of a contracting state may be taxed in such state.
Further, in terms of Article 13(4) gains from alienation of any property other than those mentioned in Article 13(1),(2),(3) and (3A) are made exigible to tax only in the state in which the alienator is a resident.
Thus, the only question for adjudication before the Hon’ble ITAT, essentially, was whether a derivative could be considered to be a ‘share’ in terms of Article 13(3A) of the DTAA, so as to allocate the taxing rights thereof to the source state.
Decoding the undefined – finding context within subtext
The term ‘derivative’ remains undefined in the DTAA. It is trite law that in finding meaning for words which remain undefined in a treaty, recourse may be made to, firstly the domestic tax laws of the-source state, secondly if such an exercise yields no results, then to other laws of the source state.
Thus, traversing the relevant domestic laws, which could provide a context specific definition of the term derivatives, the Hon’ble ITAT noted that the provisions of Section 2(84) of the Companies Act, 2013 (‘CA, 2013’) define a ‘share’ to mean a share in the share capital of a company and includes stock. It also noted that term ‘derivative’ is not defined the CA, 2013, however the same is included within the meaning of the term ‘securities’, as contained in Section 2(81) of the CA, 2013, which, by making a circular reference to the definition provided therefor in terms of the Section 2(h) of the Securities Contracts (Regulations) Act, 1956 (‘SCRA’), includes the term ‘derivatives’ within its ambit.
Further, to gather the relevant context within which the provisions of paragraph 3A of Article 13 were amended by the Central Government in 2015, the Hon’ble ITAT relied on its own decision in the undernoted case[4], wherein the interview given by the then Revenue Secretary to a media house, clarifying the Government's intentions while making the amendments to the Article 13 of the DTAA, was used as an external aid of interpretation.
Relying on the said piece of external aid of interpretation, the Hon’ble ITAT noted that it was not the intention of the Government to introduce the provision of paragraph 3A to Article 13 was to restrict source based taxation of ‘shares’ of companies resident in India and that the residence based taxation of financial instruments other than, such as derivatives and other forms of securities like compulsorily convertible debentures (CCDs) and optionally convertible debentures (OCDs) would continue to be governed by the provisions of the DTAA which existed prior to its amendment.
It is also noteworthy that, though the term derivative has not been defined in the IT Act or in the CA, 2013, the same has been defined in the provisions of Section 2(ac) of the SCRA to include:
1. A security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security;
2. a contract which derives its value from the prices, or index of prices, of underlying securities;
3. commodity derivatives; and
4. such other instruments as may be declared by the Central Government to be derivatives;
Thus, even without a reference to external aid of interpretation, the Hon’ble ITAT could have arrived at the same conclusion, by following the hierarchy of interpretation as contained in Article 3(2) of the DTAA.
Nature of Derivatives
The Hon’ble ITAT also observed that derivative contracts are essentially entered into by parties to mitigate the risks of price fluctuations of the underlying assets / instruments. Upon nature derivatives the Hon’ble ITAT expounded on the following key features:
1. That derivates are a financial contract different from the underlying asset
2. That the underlying asset can be anything and not only shares
3. That in order to trade in derivatives, the investor need not own the underlying asset
4. That the derivative contract being a separate financial instrument can be traded as it is without buying or selling the underlying asset
Thus, based on the nature of the derivatives as well, the Hon’ble ITAT held that derivatives cannot be equated to shares in a company.
Concluding remarks
The judgment by the Hon'ble Mumbai ITAT provides crucial clarity on the taxation of derivatives under the Indo-Mauritius DTAA. By distinguishing derivatives from shares, the ITAT has affirmed that derivatives, despite deriving their value from underlying assets like shares, are distinct financial instruments. This ensures that derivatives are not subject to the same taxation rules as shares, aligning with their inherent characteristics and providing relief to international investors engaged in derivative transactions.
Furthermore, the legal principle enunciated in the judgment can be appropriately invoked to support taxpayers in matters concerning the taxation of income arising from the sale of units of mutual funds, business trusts, venture capital funds, and investment funds – where analogous issues are encountered, akin to those observed in the taxation of income from derivatives.
Furthermore, the judgment underscores the importance of understanding the legislative intent behind treaty provisions and adhering to the principle of treaty override. By considering both domestic laws and external aids of interpretation, ITAT has demonstrated a comprehensive approach to resolving tax disputes. This decision not only supports a fair and predictable tax environment but also promotes cross-border investments, contributing to a more robust and transparent international tax framework.
[The authors are Senior Associate and Partner, respectively, in Direct Tax practice at Lakshmikumaran & Sridharan Attorneys]
[1] Calculus Made Easy by Silvanus P. Thompson
[2] 3 Sigma Global Fund [TS-928-ITAT-2025(Mum)]
[3] UOI v. Azadi Bachao Andolan [2003] 263 ITR 706 (SC)
[4] Vanguard Emerging Markets Stock Index Fund v. ACIT, [2025] 172 Taxmann.com 515 (Mumbai – Trib)
