7. Markets and taxation: for investors

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The economy of any nation worldwide depends heavily on the taxes collected from citizens to maintain the economic balance. Taxes are the primary source of income for the government to fulfil the nationwide needs for development. Taxes levied on various assets can be direct or indirect. It has been generally observed that people fear the income tax department. This distress can be overcome through a little acquaintance of rules and regulations. 

The IT Department has been revising the terms and conditions of penalties every year.  This leads to the increase in the number of penalties due to non-filing and misfiling of the ITR. It has become very convenient now to send a consolidated statement for all the financial activities due to PAN and AADHAAR numbers being linked everywhere. Similarly, NSDL and CDSL can send the statement for holdings across Demat accounts. 

Filing returns for investments in stocks and mutual funds can be easy, but the complications lie while trading intraday. Let us simplify the subject of Taxation to avoid the repercussions caused due to tax avoidance. 

Taxation of stocks and mutual funds

Scenario 1: A company named ABC has 1,000 shares of Stock Outstanding. As an investor Satish bought 100 shares in ABC. It will result in Satish owning and claiming 10% of the company's assets and earnings. 

Hence, ownership of stocks is defined by the number of shares you own comparative to the number of outstanding shares. 

It has to be noted that the stockholders are not entitled to own an organisation. Still, they hold a fraction of shares sold by an organisation. It is essential to note this difference about ownership of share and ownership of the organisation because the corporate property is legally separated from the property of shareholders.

Taxation of Stocks

The stock investments can be bifurcated into Capital gains or Business income (trading) as per the new guidelines laid out by the Income Tax Department. Investors can decide to show their investment as any of the two. 

  1. Stocks held for over 1 year can be considered as investments as dividends most likely to have been received and also stocks held for a long time. 
  2. Short-term equity delivery buy/sells can be considered as investments till the time frequency of buying and selling is low.
  3. Your equity delivery trades can be shown also as a business income (but whatever stance once taken must be continued in the future

Before learning about the taxation, one needs to classify himself as an investor or a trader on the basis of classifying the income under one of the following  –

  1. Long term capital gain (LTCG) (Equity holdings for more than 1 year ) 
  2. Short term capital gain (STCG) (Equity holdings between 1 day to 1 year with a low frequency of trades)
  3. Speculative business income (Trading intraday equity) 
  4. Non-speculative business income (Trading F&O (Equity, currency, commodity) 

In contrast to capital gains, business income. Speculative and non-speculative business income has to be added to all other income (salary, other business income, bank interest, rental income, and others), and taxes will be paid according to the tax slab. 

Scenario 2:

Amit earns Rs.10,00,000/- annually
Short term capital gains from delivery based equity sums up to Rs.100,000/-
Profits from F&O trading equals Rs.100,000/-
Intraday equity trading amounts to Rs.100,000/-
The tax liability can be found out by calculating Amit’s total income.
The total income can be calculated by adding up salary and all speculative and non-speculative business income.
Capital gains have fixed taxation rates hence they cannot be added.

Total income (salary + business) = Rs.10,00,000 (salary income) + Rs.100,000 (Profits from F&O trading) + Rs.100,000 (Intraday equity trading) = Rs 1,200,000/-

Amit now have to pay tax on Rs. 12, 00,000/- based on the tax slab –
0 – Rs.250,000: 0% – Nil
250,000 – Rs.500,000: 5% – Rs.12,500/-
500,000 – Rs.10,00,000: 20% – Rs.100,000/-,
1,000,000 – 1,200,000: 30% – Rs.60,000/-
Hence total tax: 25,000 + Rs.100,000 + Rs.60,000 = Rs.172,500/-

Now, additional income of Rs.100,000/- is classified under STCG from delivery based equity. The tax rate on this is 15%.
STCG: Rs 100,000/-, so at 15%, tax liability is Rs.15,000/-
Total tax = Rs.185,000 + Rs.15,000 = Rs.200,000/-

We will now proceed to find a list of important factors that have to be kept in mind when declaring trading as a business income for taxation. 

MUTUAL FUNDS

Mutual funds are considered as one of the popular investment options in the current times. 

It has been observed quite often investors do not pay much attention to tax consequences while taking investment related decisions. In that case, Mutual funds prove to be a brilliant investment option for individual investors. Why? Because 

  1. It is tax-friendly investment options available to Indian investors
  2. It brings exposure to an expert managed portfolio.
  3. Portfolio can be diversified by investing in mutual funds.

Well provided those mentioned above, not considering tax while planning to invest in mutual funds might be a wrong decision. In the absence of such concern, the cash flow will be affected. Along with taxation, an investor must take a note of certain factors like taxation on dividend, redemption etc.

Taxation of Mutual Funds 

Mutual Funds are based on the principle, “never put Earnings carried out through Mutual funds investment as capital gains”. Capital gains are taxable. The tax to be paid on the capital gains depends on the basis of:

  1. the category of the mutual fund scheme and 
  2. The time period for which the investment was held. 

Scenario 3:

Arun invested Rs. 1 lakh in a mutual fund scheme in 2018 and the value of his investment reaches to Rs. 1.5 lakh in 2020. Capital gain earned by him amounts to Rs. 50,000. 

Capital gains depending upon the period of investment held can be classified as:

  1. short term capital gains (investment in equity mutual fund sold before completion of one year from the date of purchase)
  2. long term capital gains (investment held over one year)

Hence, Capital gain earned by Arun will be termed as long term capital gains.

On contrary, in case of debt funds or any other category apart from the equity schemes, if earnings on an investment are sold before completion of 2 years is termed as short term capital gains and gains acquired by selling an investment after completion of 2 years is termed as long term capital gains.

The tax-efficiency of mutual funds depends on the period they are held for. Longer the time mutual funds units are held, the more tax-efficient. Comparative to short term gains, the tax on long term gains are lower.

Nature of Profits / Income

Equity Funds Taxation

Non-Equity Funds Taxation

Minimum Holding period for Long term capital gains

1 year

3 years

Short term capital gains

15% + 4% cess = 15.60%

As per the tax rate of the investor (30% + 4% cess = 31.20% for investors in the highest tax slab)

Long term capital gains

10% + 4% cess = 10.40% (if the long term gain exceeds Rs 1 Lakh)

20% with indexation

Dividend distribution tax

10% + 12% surcharge + 4% cess = 11.648%

25%+ 12% surcharge +4% cess = 29.120%

Taxability of dividend income

Dividend is a fragment of the earnings that a company acquires and issues amongst its investors. 

Dividend Distribution Tax (DDT) is a liability that an organisation is supposed to pay to the authority (government) according to the dividend distributed among its investors. 

As of Fiscal Year 2019-20, fund houses managing the mutual fund are supposed to pay DDT to the government instead of investors. Generally, DDT rate is around 30% in most schemes. On the other hand, as per the budget for FY 2020-21, DDT has to be paid by the investor and not the fund house. Therefore, DDT has been abolished under the new tax regime. 

A TDS is imposed on dividend income distribution by companies or mutual funds as per the Budget 2020. Per investor a 10% TDS applied to the dividend income. If the dividend receipt or mutual funds is less than Rs. 5,000 annually, no TDS can be applied.  For the FY 2020-21, the rate of TDS stands reduced to 7.5% for dividends paid till 31 March 2021. 

Scenario 4:

Sharad holds 50 shares in a Company ABC. The dividend he is entitled amounts to Rs. 2,250 by June, 2020. Since the dividend income is less than Rs. 5,000, he is not accountable to TDS. 

In other cases, Sharad holds 100 units of a mutual fund. Supposedly he is entitled to receive 7,000 as a dividend. In this case, a tax of 7.5% of the dividend income is required to be deducted which is Rs 525. 

In both the cases, dividend income of Sharad is entitled to be taxed as per the slab rates. 

Exemption from TDS:

  1. Taxpayers who are having a gross annual income is less than the basic exemption limit of Rs 2,50,000 
  2. Senior citizens whose tax payable is nil 

Notably, Senior citizens are required to submit Form 15H to the company or mutual fund declaring the dividend. 

Taxpayers below 60 years of age are required to submit Form 15G to claim exemption from TDS.

Equity Exchange Traded Funds (ETFs)

Vicky plans to go on fishing with three other friends. They decide to take some snacks along. All four of them decide to bring different snacks. After fishing, they open their basket and have a variety of delicious snacks. Vicky and his friends have had a good deal of feast on a nice fishing trip. The snacks cost low when divided per head, and at the same time, everyone can taste every delicacy available in the picnic basket. 

Similarly, ETFs are the funds which are collected when the financial resources of a group of people are pooled and used for purchase of various tradable monetary assets including shares, debt securities (bonds and derivatives). ETFs are handled by Securities and Exchange Board of India (SEBI). It is one of the most interesting options for investors with limited or no expertise in the stock market. 

Why is an ETF a better option than Mutual Funds? 

  • Reduction of expenses. It involves no extra charges unlike mutual funds which increases the total cost incurred in Mutual Funds raising the total expense ratio.  
  • Unlike mutual funds changes occurring in the value of ETF can be noted immediately and bought and sold any time during the business day
  • Higher liquidity than mutual funds. 
  • choices of investing become flexible
  • tax-friendly than mutual funds
  • Investing is less risky than mutual funds 

Shortcomings of ETF

  • A Demat account is needed in case you don’t want to involve fund managers. Basic knowledge about stock market transactions is required to operate a Demat account, which could be challenging for a novice.
  • Prices can fluctuate according to market trends. Unlike government bonds, they are unstable. Profit and loss depends highly on the conditions of the stock market.
  • Often, small scale organizations with high potential get overlooked.  Hence ETF has moderate diversity. 

Wrapping up

Now that you understand Markets & Taxation for investors are, it’s only logical that we move on to the next big topic - Markets and taxation: for traders. To discover the answer, head to the next chapter. 

A quick recap

  1. Taxation takes place while an authority (generally the government of a nation) entails a charge to be paid by citizens and companies, to that authority.
  2. Tax levied by the authority is involuntary, and contrary to other payments, not associated with any particular services being provided. 
  3. It is ensued on physical assets (comprising property and other transactions like selling of stock, or real estate) 
  4. Dividend is a fragment of the earnings that a company acquires and issues amongst its investors.
  5. ETFs are the funds which are collected when the financial resources of a group of people are pooled and used for purchase of various tradable monetary assets including shares, debt securities (bonds and derivatives).
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