Does every working day find you facing two screens—a business channel that tracks the market and your computer screen—as your fingers fly across the keyboard trying to make the most of the stock you are tracking through the day? Is trading a hobby through which you want to earn a decent sum?
If your answer is yes, here’s a word of caution: the tax laws of the land may classify your hobby as a “business” and tax your profits differently. And this is no mean burden; the tax liability will double if the income is classified as business income.
When there are a large number of transactions in a short duration, the income-tax authorities may consider gains from share trading to be taxable as business income rather than short-term capital gains. The resultant tax burden doubles for the taxpayer from 15% on short-term capital gains (STCG) tax to 30% on business income.
The problem that most investors face is the fact that there is no law that defines the gains as STCG or business income. However, in a recent ruling this month, the Mumbai bench of the Income-tax Appellate Tribunal said that the profits from PMS (portfolio management services) transactions were not to be assessed as business income but as short-term capital gains.
On the issue of whether share transactions constitute business income or capital gains, chartered accountant Gautam Nayak says it really depends on the facts of each case and no single factor or majority of factors would determine the issue.
While recognizing the importance of facts in each case, the Mumbai bench ruling bodes well for individual investors, who buy stocks with the intention of investing. Says Samir Sanghvi, chartered accountant and taxation and transaction advisor, “The assessing officer is alerted due to the frequency of transactions which may seem extraordinarily high for a given period. Then they look deeper and question other matters such as the assessee’s intention, line of work, funding and volume. The intention is what distinguishes an investor from an individual who trades professionally.”
So how do you know when you are crossing the line. Here are some factors that you may want to consider to save you the extra tax burden.
While this is not an exhaustive list of what you need to worry about when trading regularly, these are some of the few important pointers.
Says Nayak, “Factors affecting each case are different. One factor could tilt the decision for either side, and facts of each case have to be looked at independently.” He further adds that the subjective nature of the issue makes it difficult to have a concrete law—as one type of investor may be treated unfairly as compared with another.
Number and frequency of transactions
This is the first thing that alerts income-tax authorities. Says Mehul Sheth, M. Sheth & Co., Chartered Accountants, “If on a particular contract note there are a large number of trades, say 10-15 for a single day, it may raise red flags and lead the assessor to look deeper.”
This could reflect that the investor is trading often and the gains are a large contributor to the investor’s total income.
Here, the context is important, says Nayak. “It is subjective; for a corpus of Rs 10 crore, 10 transactions aren’t too much, but for a corpus of Rs 1 lakh even five transactions may seem high,” he says. The market movement at that time is also important; on a days that the market corrects substantially, the likelihood of more transactions is higher.
Amount of money and trade volume
Another factor that the assessing officer is likely to analyse is the total turnover for “suspicious” transactions. Says Sanghvi, “While there is no fixed number beyond which things appear out of ordinary, what is more important is to see the amount in context of the assessees overall surplus and risk-taking ability.”
For example, in case of a middle-level manager with gains from equity transactions worth Rs 5-10 lakh every month, income may be assessed as business income, as the amount seems too large to put at risk, given limited income. “If an investor lives on a monthly income, the risk-taking ability is also assumed to be moderate, wherein frequent trades for large amounts look suspicious,” adds Sanghvi.
Source of funds
The source of funds used for trading is another indicator that aids in deciding whether the gains are business income or STCG. In other words, from where the investor gets the money to put into the market is important.
Says Anil Rego, chief executive officer and founder, Right Horizons, an investment advisory and wealth management firm, “Borrowed funds, or funds from relatives may raise suspicion if used for trading when the volume of trades is high compared with the investor’s income.”
In a lot of cases, people trade on the behalf of relatives. As a precautionary measure trade only on your account and don’t create accounts to trade for rich relatives who have enough surplus to make gains from frequent trading in the equity markets.
Ability to take risk
An investor’s ability to take risk is also assessed. Says Rego, “Composition of capital gains to overall income is essential in such issues.” Thus, if income from capital gains is a very high percentage of the investor’s total income, assessing officer may see a red flag.
This cautions the investor not to be over-ambitious about trading in equities, rather invest only as much as your surplus permits. If income from capital gains is regularly a large percentage of the total income, it suggests that it is the main source of income and hence, can be assessed as business income.
Trading in derivatives
“Trading in futures and options or day trading requires the investor to take a high exposure (in terms of money), raising the risk of the transaction. Therefore, a retail investor who is active in the derivatives segment could also raise eyebrows,” says Rego.
Once again the frequency of trades, volume and risk are some background factors that will be considered by the income-tax authorities in such cases.