In a very short span of time with the rollout of various new discount broker apps (also known as Zerodha, Upstox, Grow, 5paisa, etc.), trading in stocks, mutual funds and Futures and Options has become extremely accessible for the common man. The aggressive advertising and coinciding imposition of lockdowns in the aftermath of COVID-19 has also resulted in a boom in trading and encouraged ordinary men to earn additional income through investing and trading. This is evident from the fact that three-fold new DEMAT accounts have been opened during the lockdown period as compared to the previous period.
As a conjoint result of both the technological advancements provided by discount brokers and the convenience of investing and trading, practically everyone, including students, salaried workers, businesspeople and professionals have begun to invest a little chunk of money in the stock market to earn some extra/side income.
These individuals may have become experts in trading over time, but due to a lack of understanding of tax regulations, they either fail to report the income/gains from stock trading to income tax or submit an inaccurate income tax return form; and both of these situations are considered as non-compliance under the Income Tax Act. This is especially crucial since, according to a recent Madras High Court decision, failing to file an income tax return might result in prosecution and imprisonment even if though the taxes have been fully paid.
Consequences of non-filing of return or non-reporting of income:
So basically, if small taxpayers choose (deliberately or inadvertently) not to file income tax returns even though they are earning income through the sale of shares, mutual funds or Futures and Options, inquiry/ scrutiny actions may be initiated by the tax department. In addition, if the income earned is under-reported, a penalty of 50% of the tax amount will be imposed. Further, ‘filing the incorrect type of income tax return’ or ‘failing to file an income tax return’ can be considered as ‘misreporting of income’ or ‘suppression of facts’ and a penalty of 200 percent of the tax amount can be levied.
Capital gain vs business income:
Thus, in order to comply with the Indian tax laws, it is imperative to understand the intricacies of taxation of share market transactions. The taxability of income/gain from stock trading is largely influenced by whether the shares are kept as "stock in trade" or "as an investment". This differentiation is also based on transactions volume, mode of delivery, frequency of transactions and payment source (either own funds or borrowed funds).
On the basis of the above principles, taxpayers have the choice of classifying their assets either as an "investment" or a "stock in trade". The rationale for picking the classification is highly essential since the taxability/head of income will vary according to the categorization of income. If the holdings are treated as "investments" then the income earned shall be considered as "Capital Gains" and must be reported under the head "Income from Capital Gains"; and if the taxpayer chooses to classify the holdings as "stock in trade" then the income earned from sale of shares will be considered as 'Business Income' and must be reported under the head 'Profits and Gains from Business and Profession'.
Tax rates and carry forward of losses:
For the purposes of applicable tax rates and time period for set-off of losses in future years, capital gain income is further separated into two categories: i) Long Term Capital Gain ('LTCG') & ii) Short Term Capital Gain ('STCG'), which is mainly based on the 'period of holding'. Further, if the shares are listed/ unlisted/sold off the market or the mutual funds are equity-oriented or debt-oriented, then the term or time period covered in 'period of holding' is subject to vary.
A synopsis of taxability of shares/ mutual funds (MF’s) based on period of holding along with applicable rates is summarized as follows:
Nature of Security | Period of Holding | Nature of Holding | Tax Rates Applicable |
Listed Equity Shares Or Equity Oriented MF’s | 12 Months or More | LTCG | 10% (excluding 1 Lac) |
Less than 12 Months | STCG | 15% | |
| Unlisted Shares | 24 Months or more | LTCG | 20% |
Less than 24 months | STCG | Applicable Slab Rates | |
Listed Debt Oriented listed MF’s/ Listed debentures | 36 Months or More | LTCG | 20% with Indexation |
Less than 36 Months | STCG | Applicable Slab Rates | |
Future & Options | Not relevant | Business profit | Applicable Slab Rates |
Further, if the taxpayer filed his return of income then he will also be entitled to carry forward and set off current year losses from future years for a period of ‘four’ to ‘eight’ years.
The income earned from trading in ‘future & option’ shall be treated as business income only which has been specifically outlined under the Income Tax Act. Moreover, if the gross turnover from such trade exceeds the Rs. 10 crore threshold limit, the Taxpayer will be compelled to file a Tax Audit Report.
Synopsis of Applicable Income Tax Forms:
In general, there are seven types of ITR forms: Forms 1, 2, and 3 are for individuals and HUFs; Form 4 is for individuals, HUFs, and firms (other than LLP); Form 5 is for taxpayers who are not individuals, HUFs, companies, or charitable organisations; Form 6 is for companies; and Form 7 is for charitable organisations. So, there are four types of ITR forms which are applicable for individual assessee, which is why there is a misunderstanding about which form is required to be submitted for which type of income.
If the taxpayer's earns income which to be taxed under the head ‘capital gain’ then he is required to file income tax return in Form 2. Further, if taxpayer earns income under the head 'capital gain' as well as 'Profit and gain from business and profession' then he is required to file his income tax return in Form 3.
To bring some cheer, it is expected (from Financial year 2021-22) that the income earned in the nature of capital gains, dividends, interest, etc. will be pre-filled in the income tax returns, which will serve as a comprehensive guide for the taxpayers in identifying reportable transactions early and assisting them in complying with the tax and filing a correct income tax return form.
Rajat Mohan is Senior Partner, and OM Rajpurohit, Director – Tax at AMRG & Associates