Today’s topic is one that needs repeated consideration, especially when a bull market like the current one is unfolding. But first, a bit of a background.
With the stock market going beyond the 31,000 points mark, to call it a bull run would be an understatement. And as it happens with every bull run, it invites investor participation. In other words, everyone wants to enjoy the party till it lasts. And what does “enjoying the party entail?” Buying and selling shares of course i.e. increasing amount of transactions in the stock market.
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 tax-free. 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:
n Period of Holding
n Volume of Transactions
n Frequency of Transactions
n Percentage of delivery based transactions as against non-delivery based transactions
n Ratio of Sales to Purchase
n 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
n During the course of the Financial Year what is the percentage of total profit booked vis a vis the total portfolio.
n 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 recognised 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.
n 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.
n Volume of purchase and sale also are important as they indicate the time taken to churn the portfolio.
n 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.
n xBorrowings 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.
To sum
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. The authors may be contacted at wonderlandconsultants@yahoo.com
