VAT treatment of Options and Option Premiums
VAT treatment of Options and Option Premiums is the latest public clarification issued by the Federal Tax Authority (FTA) vide clarification No: VATP014. This article provides an insight into the taxability of options and options premiums in the light of the above-mentioned public clarification issued by FTA.
What is the options and options premium?
A financial option is a contract which gives the buyer (i.e. the owner or holder of the option) the right, but not the obligation, to buy or sell an underlying financial instrument (equity shares, debt securities) at a specified price (i.e. strike price) prior to or on a specified future date.
The strike price may be set by reference to the spot price (i.e. market price) of the underlying financial instrument on the day an option is taken out, or it may be fixed at a discount or at a premium.
The seller has the corresponding obligation to fulfil the transaction – to sell or buy – if the buyer (owner) "exercises" the option.
An option that conveys to the owner the right to buy the underlying financial instrument at a specific price is referred to as a call option
An option that conveys the right of the owner to sell the underlying financial instrument at a specific price is referred to as a put option.
An “Options Premium” is the fee received for selling/buying an option.
Let us learn option and option premium through an illustration:
Suppose a trader in a share market expects that Company A’s equity share price may raise up to AED 100 in the next month. And the trader sees that in the next month he can buy a call options, i.e. right to buy the equity shares of Company A, at a strike price of AED 75 per share by paying an option premium of AED 5 per share. He bought an option for 100 shares by paying AED 500 (i.e. 100shares X AED 5) as option premium.
As expected, the share price increased and reached at AED 100 in the next month. The trader executes the call option and buys the 100 shares of Company A at AED75. i.e. the strike price on his options contract. He has to pay AED 7,500/ for the equity shares. The trader can then sell the shares in the market for AED10,000/ and make a profit of AED2,000/ (i.e. AED 2,500/ less AED 500/ for the options contract).
Here the price at which the trader can buy the shares in the next month is called the strike price. The amount, i.e. AED 5 per share, that the trader paid for availing such right is called the option premium.
As per Article 42(2) of the Executive Regulation (ER) of the VAT Law, Financial Services includes the provision or transfer of ownership of financial instruments such as derivatives, options, swaps, credit default swaps, and futures.
As per Article 42(4) of the ER of the VAT Law, the Financial Services listed under Article 42(2) shall be subject to tax where the consideration payable in respect of a supply of Services is an explicit fee, commission, discount, and rebate or similar. Therefore, generally, the transfer of options are taxable at the standard rate.
As per Article 42(3) of the ER, the issue, allotment, or transfer of ownership of an equity security or debt security is exempt from tax.
Now let us analyze the definitions for equity security and debt security as provided under Article 42(1) of the ER:
The phrase “equity security” means any interest in or right to a share in the capital of a legal person, or any option to acquire any such interest or right;
The phrase “debt security” means any interest in or right to be paid money that is, or is to be, owing by any person, or any option to acquire any such interest or right;
From the above definitions, equity/debt security includes the right to acquire any such securities.
Here the question is whether the transfer of rights, acquired through executing an option, to buy or sell equity shares/debt owing by any person is exempt under Article 42(4) or taxable under Article 42(3). FTA now made it clear through the public clarification that supplies of options in respect of debt securities and equity securities in return for premiums are exempt from VAT under Article 42(3).
However, at the same time, the supplies of options in respect of underlying commodities or other non-debt and non-equity instruments – where such options are supplied in return for explicit premiums are taxable as provided under Article 42(3).
How to rectify if you have done wrong tax treatment till the Public Clarification issued in this regard?
In this public clarification, FTA made it clear that, if the supplier has incorrectly charged the supply of exempt options at VAT 5% before 31st July 2019, then Tax Credit Note must be issued to the recipient in order to correct the VAT Treatment.
Furthermore, where the supplier has already accounted for that output tax on options in its tax returns, it will be able to adjust this VAT in the tax return related to the tax period in which the tax credit notes were issued, where the supplier can show that it has issued the tax credit notes and passed them on to the recipients to which the VAT was charged.
Where a VAT-registered recipient of the supply has already deducted input tax in respect of the supply, the tax credit note will also trigger the requirement to make an input tax adjustment (as a negative in the net and VAT column of Box 9) in the tax return for the tax period in which the recipient received the tax credit note.
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