The indices are ruling at life time highs. Investors are afraid that this is a run up prior to the elections and once the polls are done, markets will simmer down. And therefore, many are booking profits to cash in. Now, when you transact in the capital markets i.e. buy or sell shares on a stock exchange, you will either make some profit or incur losses.
Now, most investors know that profits on shares held for over 12 months are classified as long-term capital gains and are taxable at 10% above Rs. 1 lakh. Profits on shares held for less than 12 months are classified as short-term gains and are taxed at a concessional rate of 15%.
That being said, if you are a trader in securities, then provisions of capital gains are not applicable to your securities transactions. Instead, the profit or loss from your securities transactions would be classified under Business Profits and taxed at the full slab rate applicable to you.
Now, as mentioned earlier, when a bull run of sorts begins, generally capital market transactions of investors increase. A fall out of this phenomenon is that tax officials seek to tax such transactions as business income of the assessee rather than capital gains.
However, the problem arises in trying to decide whether one is an investor or whether one is a trader. In other words, the Income Tax Act doesn’t specify any kind of rule to determine whether one’s stock market transactions should be classified as capital gains or as business profits.
Investors, tax professionals and the judiciary have been struggling over this issue and unless and until the Income Tax department issues specific, unequivocal guidelines in this regard, the underlying circumstances of each case would only be the deciding factors.
Let us see what these underlying factors are:
Factors that go into the decision Like mentioned earlier, the tax liability on transactions entered into in the capital markets is decided upon the classification of the securities held.
If such securities are to be classified as investments, then any profits will take the form of capital gains and the provisions of the Income Tax Act for tax leviable on capital gains will apply. However, if such securities are to be classified as stock in trade, then any profits from the same will take the form of Business Income and will be taxed at slab rates applicable to the assessee.
Now, the most important test for such classification is ‘the intention of the assessee at the time of purchase’. If the assessee had purchased the securities with the motive of investments and not merely and exclusively to sell or trade in them, then the transaction is one of investment and not of trade or a business venture. Such intention can be determined by the facts and underlying circumstances of the case and some of the underlying parameters that go into such determination could be:
Period of Holding
Volume of Transactions
Frequency of Transactions
Percentage of delivery based transactions as against non-delivery based transactions
Ratio of Sales to Purchase
Source of Funds
The above however, is only an indicative and not an exhaustive list and it is always a combination of all the above factors that have to be considered in making a determination. For instance During the course of the Financial Year what is the percentage of total profit booked vis a vis the total portfolio.
The Income Tax Act, by virtue of Sec. 2(29A) read with Sec. 2(42A) defines shares held for over twelve months as long-term assets. Additionally, on account of the long-term nature of the investment, Sec. 10(38) of the Act grants exemption on such long-term capital gains earned provided the sale is carried out on a recognized stock exchange and Securities Transaction Tax is paid thereon.
Therefore, determination of the proportion of total long-term capital gain earned by the investor during the financial year as compared to the total profit booked would also throw light on the nature of the transactions. The larger the proportion of long-term capital gains, the stronger the case.
Additionally, an analysis could also be carried out to determine the proportion of profit from shares held for more than six months but less than one year and the proportion of profit booked from shares held for less than three months to the total profit.
The proportion of delivery based transactions to non-delivery based ones will also be considered as a significant factor. Transactions of short-selling or those in the Futures & Options segment if undertaken on a fairly large scale are generally considered to be something that long-term investors doesn’t indulge in much.
Therefore if all or most transactions have resulted in delivery coupled with lack of any short-sales, it is a significant factor that goes to establish the intention of the assessee of always owning the securities as investments rather than as inventory.
The assessee also needs to have been maintaining the financial records by classifying the purchase and sale as investments and not a stock-in-trade. Volume of purchase and sale also are important as they indicate the time taken to churn the portfolio.
The main business activity of the person is also an important criterion in this regard. If the assessee already has a share broking or a merchant banking business or generally a person associated directly or indirectly with the business of dealing in securities, then ITOs are known to classify them as traders.
In other words, the assessee’s capital market transactions shouldn’t be ancillary or supplementary to any other major stock market business. Borrowings is another major factor. As a precedent, the tax officials have always been considering that it is the active traders who borrow funds for investment in the stock market.
An investor normally does not borrow funds for investment, rather, he or she uses their savings to invest in stocks. A trader who borrows funds at commercial rates would try and optimize his profits to earn income over and above the borrowing cost by booking high turnover, short holding periods and would generally manage the investment in a businesslike manner.
However, times are changing fast and so is the profile of the investor. Over the past few years, interest rates in the Indian economy have been on the decline and many investors taking advantage of such low interest rates have been leveraging their investments for optimal benefit. This is a phenomenon observed not only in the secondary market but also in the primary market.
Therefore, the borrowing per se, may not as much be a business decision as a factor of the low interest rates on offer as compared to the demonstrated return potential in the stock market. Last but not the least, an act of borrowing, per se, considered absolutely, without taking into account the surrounding circumstances means little.
Else, if a home loan buyer, who has used housing finance for the purchase of his house were to sell it a later date would also have to be classified as a trader and the sale value be taken as his business income. Whether an investment has been made as part of a business or not may be examined having regard to the principle that ‘business connotes some real, substantive and systematic or organised course of activity or conduct with a set purpose’.
Whenever subjectivity enters the field of law, it doesn’t augur well for those affected. Laws have to be watertight and objective with no room for bias or prejudice. Till such time, it would always be a losing battle for the small investors of our country.
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