It is important for you to know the correct tax implications of various transactions pertaining to stock market investment. Some people think there is no tax, some like to leave the complexities of taxation to the Chartered Accountant, some just like to close their eyes to it (”not my cup of tea”). No doubts, taxation in India is fairly complex, yet taxation of securities is not complex, and the provisions are fairly unambiguous. Since tax is a cost to be factored in while calculating return on investments, it is important that you understand your taxes well. The government loves to present tax in a language incomprehensible to most of its subjects, except a small tribe of tax experts. Let me hack it for you and present it in plain English.
Income Tax Act likes to distinguish between an investor,speculator and trader for the purpose of tax treatment. If you are buying and selling shares intra-day, that is, you square off your transactions without taking delivery, you are considered a speculator. If you buy and sell frequently, with each stock coming in and going out of your DEMAT account, you may consider yourself a trader.
If you are an investor, income arising from sale of your shares is considered as ‘capital gains’. Income from trading is considered as business income. We will discuss the two categories and its sub-categories separately.
First the investment income. Since you are reading this book, I presume, you are a long term investor, and are more interested in this section. Let us understand the taxability applicable to you as an investor. Tax depends upon the holding period, that is, for how log have you held the share before selling it off. Long term is encouraged, and you pay less tax when you hold a share for a long term. The law divides income from capital gains into i) short term capital gains, ii) long term capital gains. Let us understand the two concepts:
The law has a fairly simple definition of short term, investment held for less than one year is considered a short term investment, and an investment held for more than a year is considered a long term investment. This is fantastic from the point of view of investors, since most of you will be holding many of your investments way beyond one year, so your investments will fall in the category of ‘long term investment’ qualifying for a soft tax treatment.
Short Term Capital Gains (STCG)
When the shares are sold within 12 months of their purchase, the profit on sale of such shares is called the short term capital gains, and is taxed at a flat rate of 15%.
I buy 100 shares of Maruti Suzuki on June 2018 for Rs 6000 a share, and sell them off in November 2018 for Rs 6800, the short term capital gains will be :
Sale Price Rs 6,80,000
Purchase Price Rs.6,00,000
Short term capital gains Rs 80,000
Tax @ 15% Rs 12,000
Please keep a couple of things in mind regarding this:
- Short term capital gains is taxed at a flat rate of 15%. This is likely to be lower than the rate at which your other income is taxable. Of course this is higher than the tax on long term capital gains, still tax @ 15% may be considered quite a low rate of taxes. In any case, my wish is that the readers of this book change their investment strategy and stay invested for a long term, so that they pay even less taxes than this.
- This concession on short tax capital gains is available only to a special class of assets, which includes equity shares. This concessional treatment is not available in respect of other class of assets (example, land, machines) where tax treatment is different.
- The law requires that this concessional treatment is available only if Securities Transactions Tax (STT) has been paid on the sale of such shares. Simply stated, STT is the tax that your broker collects from you when you sell your shares through him. It implies that your shares are being sold through a stock exchange in India( your contract note from broker will show details of STT paid), and are not off market transactions, or sale against buy back offer by company, in which cases this concessional treatment will not be available to you.
Let us now consider the long term capital gains.
Long Term Capital Gains (LTCG):
Long term capital gains arise when you hold your investments for more than one year. The rate of tax on capital gains is 10%, but the effective tax rate is likely to be much lower, for reasons explained below.
- If the capital gains during the year is less than Rs 1,00,000 there will be no tax. LTCG up to Rs 1,00,000 is exempt from tax.
- If your LTCG is Rs. 1,50,000 tax will be payable on Rs 50,000 alone, after deducting the exemption of Rs 1,00,000.
- On the capital gains beyond Rs 1,00,000 law allows you concessions to reduce your liability further. Suppose you had bought 100 shares of Azko Nobel in 2015 for Rs 1000 a share. And you sell them today in November 2018 in Rs 1500 per share. The tax treatment will be as under
Purchase Price Rs. 1,00,000
Sale Price Rs. 1,50,000
There is a capital gain of Rs 50,000 in the transaction, but as said before let us explore additional concessions available.
The law says that for shares purchased before 31st January 2018, which are long term capital assets (that is, held for more than 12 months) you have an option of substituting the price as on 31st January 2018 instead of the purchase price. Let us say the price as on 31st January 2018 was Rs. 1200.
Now the figures change as below:
Purchase price ( deemed) Rs. 1,20,000
Sale Price Rs. 1,50,000
Voila! The capital gain has been reduced to Rs 30,000 now instead of Rs 50,000.
The rate of tax being 10%, your tax will be Rs 3,000. Of course, if you have not sold any other shares during the year, there will be no tax, the exemption of Rs 1,00,000 will take care of that.
Please keep in mind the following:
- As explained in the case of STCG, concessional treatment will be available only if the STT has been paid on the transaction.
- This special treatment is available to equity shares and some special assets alone.
Let us now consider taxability where income is not considered a capital gain, but as business income
- Income from intra-day trading
Income from intra-day trading is considered is speculative business income. If you buy in the morning, and sell in the afternoon; or conversely if you sell in the morning, and buy it back in the evening, the income is considered a speculative business income.
- Income from Futures and Options (F&O)
F&O may be speculative instruments from the point of view of readers of this book, however the tax law do not consider them speculative, because some people use F&O for hedging, so they may be legitimate non-speculative transactions (Though I suspect, the lawmakers want to promote F&O, thus this special treatment)
Income from speculative and non-speculative business are clubbed together and added to your income and charged to tax at normal rate. Rate of tax depends upon your income slab, and could vary from 0 to 30%. The only difference between speculative business income and non-speculative business is that losses arising out of speculative business (to recall, intra-day trading) cannot be set off against the income arising out of non-speculative business (that is, F&O). In short, intraday is discouraged, but not F&O.
Tax on Dividends
Dividends receive from an Indian company are tax free. The company is required to pay a dividend distribution tax before it pays you dividends. So as far as an investor is considered, whatever he gets from his investments as dividends is exempt from tax.
However in the case of a resident individual/HUF/Firm, the dividend shall be chargeable to tax at the rate of 10%, if the aggregate amount of dividend received from a domestic company during the year exceeds Rs 10,00,000. Thus, if you receive 12 lakhs as dividends, after deducting the exemption of Rs 10 lakhs, the remaining 2 lakhs will be put to tax @10%, the total tax will be Rs 20,000.
Note that dividends received from foreign companies are taxable.
Tax is an important variable to consider
Having understood the taxability of investment income let us delve deeper into it. This book is about long term investment, and discourages speculation and short term investments. Our investment period is five, ten, twenty, or thirty years, or even lifetime. So not many of your transactions will fall under taxation for trading, and for short term capital gains. Only a few, for example, you buy a stock only to discover later that your fundamental assumptions were wrong, and need to sell them, would come in the categry of short term capital gains. In my investing life spanning across more than 3 decades, I have not earned a single rupee from either speculative or non-speculative trading. I hope you also emulate my example.
Dividends are a welcome source of income, and the best part is, it comes tax free. However, the dividend payout ratio of good companies is usually very low. Whatever you get is tax free, but you don’t get much.
Let us talk about the tax that we all are concerned with, tax on long term capital gains. Tax rate is 10%. This 10% tax is payable when you sell your shares. If you are following the investment philosophy explained in this book, you will be selling your shares after holding them for many years. The liability arises at the exit point. It means as your capital continues to appreciate, you pay NO tax. You can watch your investment turn into a ten bagger or a multi-bagger. Without paying a cipher penny as tax. Only when you sell it will the liability be attracted. If you understand time value of money, the liability paid 10 years from now, has very little money value now. Your effective rate of taxation thus comes to a ridiculously low figure.
A short term investor pays a very high tax. First, the rate of tax to a short term investor could range from 15% to 30% depending upon whether he is a speculator, or a short term investor. Secondly, the tax is required to be paid in advance, or during the year in which he earns it. Thus his outflow is higher and its earlier. This reduces the funds available to him for compounding, reducing the overall return.
STT is also a major dent on the corpus of a short term investor. Since the short termer would be trading frequently, he pays substantially higher STT, since the STT is to be paid on every contract note. The long term investor buys far too infrequently, and sells even less infrequently. Thus he saves a lot from STT, STT is to be paid upfront on every transaction, thus it similarly reduces the investible funds, resulting in lower compounding. One often ignored component is the brokerage paid on transactions. The brokerage curve runs parallel to STT curve, and the more frequently you trade, the more is the money you make for your broker. When you trade very frequently, you deserve letter of appreciation from two set of people you toil for: the government, and your broker.
©Dr. Tejinder Singh Rawal
M Com, MA (Economics), MA (Public Administration), MA (Urdu), LLB, FCA, ISA, CISA, CISM, PhD
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This discussion will be a part of the forthcoming book by me “The Smart Long Term Investor: Common Sense Strategies for Wealth Creation” Suggestions are welcome and will be appreciated