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Handling taxes & stocks: Your management guide

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Handling taxes & stocks: Your management guide
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Handling taxes & stocks: Your management guide - June 4th, 2006

The stockmarkets may be in a meltdown mode these days. But that’s certainly not going to take away the charm of investing in your preferred shares. Do that as you please, but do also remember whether you are investing in stocks as a trader or an investor. Well, that’s important because there’s a different set of of income tax rules for each of them.

Read the basics first. As per section 10(38) of the I-T Act 1961, the long-term capital gains arising out of selling shares held for over a year are tax-free, particularly when such transactions are chargeable to securities transaction tax.

This will be the tax treatment only when the person is an investor and not a trader. Similarly, when the short-term capital gain arises for such investor on shares etc. after holding for less than a year, then the tax liability accrues at the rate of 10% only.

However, for all those tax payers who are traders in stocks, the above set of liberal tax treatment will not be applicable. This is because of the fact that a trader in stocks will be subjected to income tax on the gains as being treated as ‘income from business or profession’. The tax liability on business income does not enjoy any special tax benefit. Similarly, there is no concessional tax rate for persons in business or profession deriving profit on sale of shares.

Now the biggest problem has been how to distinguish between a trader and an investor. Surely, most taxpayers would love be treated as an investor and not as a trader mainly because of beneficial tax provisions. The issue is not free from doubt. There lies a very thin line of distinction between being treated as a trader or an investor. Even in the past, the courts have found it difficult to provide clear cut guidelines to solve this problem.

The issue was discussed by the Central Board of Direct Taxes vide instructions No. 1827 dated 31-8-1989. In these instructions, the government also realised that whether a particular assessee is a trader in shares or the shares are held as capital assets sometimes gives rise to disputes and litigation.

CBDT also appreciated the principles in this regard which were laid down by the Supreme Court of India in the case of G Venkata Swami Naidu & Co. v. CIT (1959) 35 ITR 594. In this case, the Supreme Court was dealing with a question whether the excess sum realised on the sale of some plots was assessable as income from an adventure in the nature of business. The Supreme Court held that in deciding the character of such transaction, several factors were relevant. For instance:
• Whether the purchaser was a trader and the purchase of the commodity and its resale were allied to his usual trade or business or were incidental to it.
• The nature and quantity of the commodity purchased and resold - if the commodity purchased is in very large quantity, it could tend to eliminate the possibility of investment for personal use, possession or enjoyment.
• The repetition of the transaction.

The Supreme Court also discussed the test of intention. It held that in cases where the purchase has been made solely and exclusively with the intention of resale at a profit and the purchaser has no intention of holding the property for himself or otherwise enjoying it or using it, the presence of such intention is a relevant factor and unless it is off-set by the presence of other factors, it would raise a strong presumption that a transaction is an adventure in the nature of trade.

In the above instructions, various other leading judgments were discussed in greater detail. Finally, CBDT said that although the tests laid down by the courts might help determine the issue in particular cases, the decision would ultimately turn on the facts of each case.

Indeed, the issue of trader or investor has been a matter of dispute for the last 50 years. Innumerable judgments, but still no specific and complete guidance on this point is provided by the judiciary nor the Income-tax Act & Rules. It is in this context that CBDT has decided to issue supplementary instructions to provide further guidelines for determining whether a person is a trader or an investor in shares. The following is the checklist of supplementary checklist provided by CBDT through draft instructions:
• Whether the purchase and sale of securities was allied to his usual trade or business/was incidental to it or was an occasional independent activity.
• Whether the purchase is made solely with the intention of resale at a profit or for long term appreciation and/or for earning dividends and interest.
• Whether scale of activity is substantial.
• Whether transactions were entered into continuously and regularly during the assessment year.
• Whether purchases are made out of own funds or borrowings.
• The stated objects in the Memorandum and Articles of Association in the case of a corporate assessee.
• Typical holding period for securities bought and sold
• Ratio of sales to purchases and holding.
• The time devoted to the activity and the extent to which it is the means of livelihood.
• The characterisation of securities in the books of account and in balance sheet as stock in trade or investments.
• Whether the securities purchased or sold are listed or unlisted.
• Whether investment is in sister/related concerns or independent companies.
• Whether transaction is by promoters of the company.
• Total number of stocks dealt in.
• Whether money has been paid or received or whether these are only book entries.

The basic objective of the above checklist is to provide further guidelines for determining whether a person is a trader in stocks or is an investor in stocks. However, the above instructions are right now only draft instructions and CBDT has invited comments on these draft instructions from public.

It is expected that the final instructions from the office of CBDT would arrive shortly. However, even these draft instructions are not a clear guide in distinguishing between shares as stock in trade versus shares as an investment.

Since the above mentioned points are themselves very confusing, it is expected that each specific case of a taxpayer would require application of mind of the income tax officer, which however would cause a lot of litigation as in the past. The best criteria which I feel would put an end to this age old problem is that the tax department should see the character of securities transactions in the books of account of the taxpayer and should find out whether in such books of account the stock value appears as closing stock in the balancesheet of the tax payer or does it appear as investment in stocks.

This one single criteria should decide the tax treatment of shares whether stock of business or investment. The other parameters pointed out in the draft instructions would just make the situation very grave as there would not be one standard method which is uniformly to be applied to all categories of tax payers. It is hoped that CBDT would take a little more pain to provide a fineprint of the instructions in this regard with the aim of providing hassle-free tax assessments to the tax paying public.

The government has extended the last date of sending comments to June 15, 2006. The tax paying public as also the chambers of commerce should send their comments as also suggestions to the Central Board of Direct Taxes. After receiving the comments, the government would come out with some new set of instructions to solve the problems arising out of tax treatment of shares as stock-in-trade and shares held as investment.

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