Income Tax

Implications of Income Tax on Your Stock Markets Investment

For those who are new to stock markets investing or have been doing so for a while but are only now facing the burden of taxes, it is critical to understand the tax liabilities of their stock gains and trades. That, however, is easier said than done. The stock market is much larger than any of us could have imagined. Even for tax purposes, the scope of the stock market is quite broad, making it difficult to determine the taxability of a specific stock trade or profit.

The government, on the other hand, doesn’t care if you’re a novice or an expert in the stock market. Your profits must be taxed. And, when filing your annual income tax returns, you must include your stock gains as well as all other sources of income. Scroll down to check more information regarding Stock Markets.

Three major types of taxes in the stock markets

People commonly wonder whether their investment in stock markets will result in additional taxes, despite the fact that the outcome cannot be predicted. Will investors still be taxed if they lose money? The simple answer is that any income from stock markets trading is taxed. However, there are other taxes too levied by the government on share trading, regardless of whether an investor makes a profit or a loss.

All investors in the stock markets are put subject to three types of taxes. These are Securities Transaction Tax, Capital Gains Tax, and Dividend Distribution Tax.

Securities Transaction Tax

The Securities Transaction Tax (STT) is a direct tax imposed on the purchase or sale of all securities listed on recognized stock exchanges, including shares, equity mutual funds, and derivatives. In other words, investors must pay it for each transaction, and it is intended to deter them from evading taxes.

Capital Gains Tax

When an investor sells a security for a higher price than the price at which they bought it, this is known as capital gains. For example, a stock can be purchased for ten lakh rupees and sold for fifteen lakh rupees three years later. The capital gain, in this case, would be five lakh rupees, and the tax on that gain would be called Capital Gains Tax. However, in order to calculate capital gains, an investor must sell his or her stock in the open market.

Based on the holding period, capital gains are taxed as either short-term or long-term capital gains. Gains realized on these transactions are considered to be short-term gains and are subject to a 15 percent tax rate if the securities are held for less than 12 months.

Long-term capital gains apply to the stocks in the stock markets held for more than a year or 12 months. Moreover, long-term capital gains from the trading of listed shares are currently tax-free, but there are some conditions attached.

Dividend Distribution Tax

Dividends are a form of income for a company’s shareholders (who are the recipients of dividends declared by a company), and they should ideally be taxed. Individuals receiving dividends were previously only required to pay a 10% DDT if the dividend amount exceeded ten lakh rupees. Following Budget 2020, regardless of the amount of dividend received, the recipient of dividends must pay income tax at the applicable rates.

Delivery-based Trading or Investments and Intra-day Trading

The income tax implications on your stock markets differ according to the types of investment you make. These stock markets can be divided into delivery-based trading or investments and intra-day trading.

Delivery-based trading or investments (LTCG and STCG)

STCG – Short-term capital gains

If you invest in equity shares or equity-related mutual funds and sell them within 12 months of the purchase date, it means you would have made a short-term capital gain. Short-term capital gains on equity shares are taxed at a rate of 15% (plus, applicable cess).

Short-term capital gains = Sale price minus Expenses on Sale minus Purchase price

If your total short-term equity transaction results in a loss, i.e., if the total sale consideration of all your short-term equity investments in a financial year is less than their total cost in that particular financial year, it is considered a short-term capital loss. This loss will be carried forward for another eight years. This means that the taxpayer can use the gains earned over the next eight years to offset the short-term capital loss. For example, if Mr. X suffers a short-term loss of one lakh rupees in FY 2020-21, that loss can be carried forward for the next eight years until it is completely offset by any capital gain.

It should be noted, however, that a short-term capital loss can only be offset against short- or long-term capital gains. Such a loss cannot be offset against any other source of income, such as a salary or a home property income.

LTCG – Long-term capital gains

Furthermore, long-term capital gains will be considered if you invest in equity instruments and sell them after a holding period of 12 months beginning from the date of purchase of such instruments (LTCG). Prior to the introduction of the 2018 budget, long-term capital gains on the sale of equity shares or equity-oriented units of mutual funds were tax-free under Section 10(38) of the Income Tax Act. But now if the total LTCG on equity shares in one financial year exceeds Rs. 1 lakh, it is taxable at a 10% rate. As a result, if your total LTCG in a financial year is less than Rs. 1 lakh, you will not have to pay any tax under the long-term capital gain head.

Similarly, if you have accumulated a long-term capital loss, you can carry it forward for the next eight years to come. It should be noted, however, that long-term capital losses can be offset only against the long-term capital gains. You can’t even deduct this loss from short-term capital gains because the Income Tax Act, 1961 prohibits deducting low-rate taxable income (i.e., 10 percent in the case of LTCG) from high-rate taxable income (i.e., 15 percent in case of STCG).

Intraday Trading

The purchase and sale of equity shares occur on the same day in intra-day trading, i.e., the trader or investor does not deliver the shares. The trader does not intend to engage in trading business but rather intends to profit from price fluctuations caused by demand and supply. As a result, under the Income Tax Act 1961, intraday trading transactions are classified as “speculative business income.”

Such speculative income will be added to total income and taxed according to the taxpayer’s normal tax bracket. Individual taxpayers, for example, will be taxed according to the old or new tax regime, depending on the situation. For corporations, however, the current tax rate will apply to speculative income.

If you lose money in intraday trading, you can carry it over for the next four years. Due to the speculative nature of the income, the carry-forward period is shorter. It’s also worth remembering that speculative losses can only be offset against speculative gains. This means it can’t be deducted from any other source of income.

How to classify income from shares as business income or capital gains?

It is also worth noting here that the income tax department categorizes the profits earned from the selling of shares as either business income or capital gains. If a taxpayer holds the equity shares as “stocks” in the stock markets, the proceeds from their sale will be considered as “business income”. And if the gains are classified as business income, they will be taxed at the taxpayer’s normal tax slab rates.

The distinction between ‘business income’ and ‘capital gains’ in equity market gains is widely debated. As a result, as a taxpayer, you should be aware of the circumstances under which the income tax department will consider your income from the sale of equity shares to be business income.

Given below are some of the important points to consider when figuring out as to whether your income from the sale of equity shares is a business income or not:

• If the taxpayer records the shares as an ‘investment’ in his books of account, the gains will be taxed as capital gains. If the shares are recorded in the books as a ‘stock in trade,’ they will be treated as business income. As a result, every investor must keep books of accounts and label them as “investments” in order to be taxed at lower rates under the capital gains head.
• If you own shares in the name of a corporation or a partnership firm, the entity’s charter document (such as the memorandum of association for corporations or the partnership deed for partnerships) should not include a provision referring to the treatment of equity shares as a ‘stock in trade’. If it is referred to in the charter document as “stock”, it will be treated as business income.
• The frequency and volume of the purchase and sale of equity shares will also be considered by the income tax department. For example, suppose you invest Rs. 10 lakhs in the financial market but generate a revenue of around Rs. 1 crore in a fiscal year. Such a high volume implies that you treat the transactions as “business” rather than “investment.” As a result, the classification of income would be determined by the number of shares traded or the volume of trade. The less you buy and sell, the more likely it is that it will be classified as an asset and thus reduce your tax liability. If there are more purchases/sales, it will be taxed as regular business income.
• The holding period of securities can also be used to determine how income is classified. If you buy some shares today and sell them within two days, it demonstrates your intention to trade on a regular basis. If, on the other hand, you sold these shares after six months, you intend to invest for a longer period of time. As a result, the duration of your open trade will also determine your classification.
• Finally, the trader’s or investor’s intent can be used to determine whether the transaction was carried out as a routine transaction or for the purpose of long-term wealth creation.

Debt funds or bonds

Debt instruments are fixed-income securities in which the borrowers are obligated to pay interest and principal to the investors. Debt mutual funds are a type of pooled fund that invests in debt instruments.

Corporate debentures, bonds, government securities (G-Secs), and debt-oriented mutual funds are all examples of debt instruments. The following is the tax treatment of income earned on debt instruments in the form of capital gains on sale or redemption of instruments:

If you sell debt instruments such as debt mutual funds and bonds (except zero-coupon bonds) after less than 36 months, the gains will be considered to be short-term capital gains and will be taxed according to your normal tax bracket. The losses on such debt instruments can be carried forward for the upcoming eight years and can be offset against any other income.

If you sell a debt instrument after holding it for more than 36 months, it will be considered as long-term and subject to a 20% tax rate. Capital losses from long-term debt instruments can also be carried forward for the next eight years, but they can only be offset against long-term capital gains.

Even in the case of long-term gains, keep in mind that bonds and debentures do not qualify for indexation. Under the Income Tax Act, the benefit of ‘Indexation’ is available in terms of long-term gains. Indexation refers to adjusting the asset’s cost over time using the government’s ‘Inflation’ index, which is updated on a regular basis.

The benefit of indexation is, however, available in respect of capital-indexed bonds issued by the Government or Sovereign Gold Bond issued by the Reserve Bank of India under the Sovereign Gold Bond Scheme, 2015 or Zero-coupon Bonds^[1].

Taxability of derivates

Derivative instruments are those instruments whose value is derived from one or more underlying assets, such as commodities, currencies, metals, and bonds. Gains from derivative instruments are typically recorded in the form of business income or other sources of income (income from other sources).

Transactions of trading in derivatives conducted on a recognized stock exchange are not considered to be speculative in nature, according to the provisions of Section 43(5) of the Income Tax Act 1961. Capital gains from derivative instruments are taxed at the slab rates applicable to different individuals because they are in the nature of income from business or income from other sources.

Conclusion

The choice of appropriate investments in stock markets is critical for both the preservation and appreciation of an investor’s capital. When it comes to investing in listed securities, a variety of factors must be considered, including your investment goal, time horizon, risk-reward analysis, as well as risk appetite, liquidity, tax incidence, and value buying.

Moreover, a holding period of more than 12 months is considered as long term in order for gains from equity shares to be taxable. In other words, if you hold your equity stock investment for more than a year, you will be subject to long-term capital gain tax.

Gains on equity shares held for less than a year are considered to be short-term capital gains and are taxed accordingly.

Read our article:A Brief Understanding on Investment in Equity Shares & Tax planning