GETTING PREPARED FOR TAX FILING SEASON
As the tax season approaches, we look at one of the most important part of the income tax, which is capital gains. Capital gains may not have too many provisions, but it is a lot more nuanced. For example, there are short term capital gains, long term capital gains, business income that is speculative and business that is not speculative. You must have a hang of each of these. Hopefully, you have not missed your advance tax deadline for the fiscal year FY24 as that will entail a penalty, but the purpose here is go a lot more rudimentary.
We look at what are the benefits that investors get as investors in stocks and how these different types of income from the share market are defined, classified, and taxed. Interestingly, capital gains are one of the economical sources of income since even the peak rate of capital gains tax on short term capital gains is just 15%. That is much lower than what you pay as the peak rate in case of interest, dividends, and salaries. There is also confusion as to when you should show income from stock profits as capital gains and when you should show it as business income. We offers answers to that too!
HOW IS INCOME ON SHARES TAXED?
When you invest in stock or shares in the stock market (be it as short term trading or long term investing), there are two kinds of incomes that are normally generated. Firstly, there is the dividend income as and when it is declared by the company. Second is when you sell these shares, either partly or in full. In such cases, the capital gains tax comes into play. The capital gains is charged based on the period of holding. If it is held for more than 1 year, it is long term capital gains (LTCG) and if held for less than one year, it is short term capital gains (STCG). We shall understand each of these in details, but first let us address another issue.
When you trade shares and you earn profits, how do you show it. For example, if you are an infrequent player in the stock market, then the gains will obviously be treated as capital gains. However, if you are a very frequent trader in the stock markets, then you will have to show the income as business income, and not as capital gains. This business income will again be further classified into non-speculative business income and speculative business income. For instance, gains from trading in stocks and futures & options (to the extent you are hedged back-to-back) will be included as non-speculative business income. However, income from intraday trading and income from F&O to the extent not hedged back-to-back, will be treated as speculative business income. Let us now go step by step to understand the tax implications when we start investing and the tax impact of investing money.
DIVIDEND AND CAPITAL GAINS – HOW THEY ARE TAXED?
Any dividend declared by the company is now fully taxable in the hands of the investor at the peak rate applicable to the investor. So, if the investor is in the 20% tax bracket then dividends get taxed at 20% and if they are in the 30% tax bracket, then dividends will get taxed at 30%. Now that dividends are taxed entirely in the hands of the investors, there is no dividend distribution tax (DDT) applicable any longer. Also, now dividend paid out attracts 10% tax deduction at source (TDS), if you annual dividend income exceeds ₹5,000 per annum. Then what are capital gains? Capital gains are realized profits, when the selling price of a stock is more than the purchase price of the stock. It becomes LTCG or STCG, based on the holding period. Based on this classification, we have Long-term capital gains and Short-term capital gains. This classification is done based on the holding period. It is the time duration from the date of purchase to the date of transfer or sale of shares.
Of course, the definition of capital gains will differ based on the assets. Here will only stick to equity, which includes direct equity and equity funds. Remember, capital gains only apply to assets. Since futures and options are contracts, there is no question of capital gains on F&O transactions. Similarly, since intraday transactions don’t result in delivery, there is no question of capital gains on intraday trading gains also. The rules are same for all listed securities are approximately the same. Here is how LTCG and STCG are classified for shares.
- Let us start with STCG. If equity shares that are listed on a recognized stock exchange are sold within 12 months of purchase at a higher price, the seller is said to have made short-term capital gains (STCG). However, if they have sold at a price lower than the purchase price, then they have incurred a short-term capital loss (STCL). Short-term capital gains are taxed at the rate of 15%. What about short term losses. The short term losses can be adjusted against short term capital gains and against long term capital gains. In addition, such losses can also be carried forward for 8 years to write off against future profits.
- Let us now turn to LTCG. If equity shares that are listed on a recognized stock exchange are sold after 12 months of purchase at a higher price, the seller is said to have made Long-term capital gains (LTCG). However, if they have sold at a price lower than the purchase price after 12 months, then they have incurred a Long-term capital loss (LTCL). Long-term capital gains are taxed at a flat rate of 10% above the threshold of ₹1 Lakh per year. For instance, if you earned LSTCG of ₹2.50 Lakhs in the year, then the 10% tax will only apply to ₹1.50 Lakhs of LTCG. What about Long term losses. The Long term losses can only be adjusted against Long term capital gains. In addition, such losses can also be carried forward for 8 years to write off against future gains.
An important point to remember here is that the above two methods only apply when you are treating your share market income as capital gains and these shares are listed on the stock exchange. When you are calculating the capital gains, you can deduct the cost of brokerage and other statutory costs. However, STT cannot be deducted and it is an inadmissible expense while calculating the capital gains.
UNDERSTANDING THE GRANDFATHERING CLAUSE ON SALE OF LONG TERM SHARES
When we try to understand the tax implications when we start investing and the tax impact of investing money, one important clause is the grandfathering clause. Buy why. Let us say, you bought Stock Y at ₹550 in 2013. On January 31, 2018 a day ahead of the Union Budget was presented on February 01, 2018, the stock price was at ₹1,450. Now why is this date relevant? This was the budget that reimposed tax on long term capital gains, which was exempt till then. Under the grandfathering clause, you get an exemption for the gains made till January 31, 2018; since the LTCG was tax free till then and DDT was already paid.
To understand the grandfathering clause must be undertook with the two key values.
- Value I is the fair market value (FMV) as of January 31, 2018, or the actual selling price, whichever is lower
- Value II is the Value I or the actual purchase price, whichever is greater
- Long-Term Capital Gain = Sales Value – Acquisition Cost (as calculated above)
Now let us go back to our illustration of Stock Y which you bought at ₹550 in 2013 and stood at ₹1,450 on January 31, 2019. On May 04, 2018, you sold the stock at ₹1,513. Here is how the LTCG calculation under Grandfathering clause will work.
- Value 1 (FMV is ₹1,450 and selling price is ₹1,513). Hence Value 1 is the lower of the two which is ₹1,450.
- Value II is the greater of ₹550 or ₹1,513 whichever is greater; which is ₹1,513.
- LTCG = ₹1,513 – 1,450 = ₹63.
Hence, in the above case, you only pay capital gains on the additional gains of ₹63 made post the relevant budget date. That ensures fairness. In the above case, it must be remembered that the Direct Tax Code is only applicable from April 01, hence if you had sold the shares before March 31, 2018, there would have been no capital gains tax on you.
CAPITAL GAINS VERSUS BUSINESS INCOME: HOW TO CHOOSE
That is the most important point to address. There are not clear cut rules or had and fast classifications here. The CBDT only says that whatever system you adopt, you should be consistent. However, past experience is that the CBDT would prefer that aggressive traders in equity also show their income as business income rather than as capital gains to give the correct picture. In case, you are an aggressive equity trade, it is safer to treat the income as business income rather than treating them as capital gains. There are some broad rules that you can follow.
- In case there is significant share trading activity in terms of volumes (either real or notional), it is advisable to show the same as business income. Significant has not been defined, but it is based on discretion of the investor.
- Here is a reference point that you can use to classify capital gains versus business income. If you have a good deal of intraday trades, it is preferable to show the income as business income as intraday is speculative income and cannot be clubbed as capital gains, since no asset is created or purchased here.
- Similarly, in the case of F&O, whether the volumes are large or medium, it is best to show them as business income to avoid any queries from the tax department. In such a case, you are required to file ITR-3, and your income from share trading is shown under the header of “Income from business & profession.”
The CBDT only says that the classification adopted must be consistent in future years also to avoid set off confusion. However, if you are an aggressive trader in equities, or are involved in F&O and intraday trades, it is best to show your income as business income. Consistency is the key, especially when it comes to carrying forward losses to future years.
WHAT ABOUT TAXATION OF BUYBACKS?
Post the Finance Bill 2019, the taxation of buybacks has been largely streamlined. Prior to that these buybacks were classified into listed companies and unlisted companies. Post 2018, even in the case of listed companies, there is no buyback tax payable by the shareholder. However, the company in question is required to pay the buyback tax on the difference between the buyback price and the issue price. On these profits, the company pays buyback at the rate of 20%, plus 12% surcharge and any applicable cess from time to time. This has become quite controversial with some legal experts insisting that it was unfair that staying shareholders are footing the tax bill of the outgoing shareholders. However, the government is yet to take a final view on this subject; despite persistent demands from the investor associations and the trade bodies that the onus of tax be put back on the investor. We could hopefully get a final word in the full budget presented in July 2024!