Cost of churning

Reshuffling your portfolio? Check this recent I-T ruling on why and how such gains should be treated.

While the markets are moving in a range-bound zone over the past couple of months, most investors are trying to make the most out of it, buying on every fall and selling on gains. But such short-term buying and selling may result in gains or losses for the investor. However, he needs to remember that such transactions are subject to taxes. So, will it considered as business income or capital gains?

While our tax laws do not have specific provisions on this aspect, judicial decisions, on the same, have helped the tax payers’ case. Let’s go through a recent case that was recently decided by the income tax tribunal at Mumbai. The case dealt with the principal issue on whether the surplus or losses on shares held for less than 30 days in respect of purchases and sales done through stock exchanges is a business income or business loss.

PRELIMINARY ORDER
In the said case, the tax payer was engaged in the business of share trading and investments and offered income from sale of shares by way of short-term capital gains (STCG) and long-term capital gains (LTCG). Gains incurred on shares that are sold within a period of twelve months, are considered as STCG. Gains made on shares sold after one year are considered as LTCGs.

However, in the said case, the tax officer treated all gains incurred on transactions terminated within 30 days, as business profits. His reasoning for the same was that the tax payer was frequently involved in systematic and regular trading activity . Going by the ratio of purchases to opening balance of shares and sales to the closing balances, the officer considered the tax payer as a trader dealing with shares rather than investor. So, the officer held the tax payer was engaged in the activity of earning profit through dealing in shares. He, accordingly, treated the entire income as business income.

At the first level of appeal, the appellate authority had asked the tax payer for a statement of STCG and LTCG. He was also asked to bifurcate the STCG into shares sold within 30 days of purchase and those sold after. Though the shares were purchased using own funds, there was not a single instance where the tax payer had squared off the transaction on an intra-day basis without taking delivery of shares. It finally held the gain arising on shares held for more than 30 days was STCG, while those on shares held for less than 30 days was to be treated as business income. The tax payer was not happy. Under the law, business income is taxed at the slab rate that one comes under. But, if the same was treated as STCGs, he would be paying lower taxes. He appealed to the Tribunal, being the appellate authority.

TRIBUNAL FAVOURS TAX PAYER
The Mumbai Tribunal, while ruling in favour of the tax payer, made some noteworthy observations. Readers could use these as guiding principles for tax planning with regards to shares.

Now the investor’s intention, frequency and source of funds while dealing in the shares would also be considered as an important aspect before drawing up a conclusion. The Tribunal held that the period for which the shares are held by an investor is not the only criterion to be applied to determine if the transaction was a trading or an investment activity.

The other principles to be applied are one - the intention of the investor at the time of purchase; two, whether the shares were purchased using borrowed funds; three, the frequency of purchase and sales; and, four, the treatment of the purchase or sales in the books of the investor. According to the Tribunal, no single criteria can be conclusive, and and an overall view has to be taken in deciding between the two activities conducted by the investor.

In the given case, the Tribunal observed, even the gains on shares held for 30 days and less had to be treated as STCG and not business profits. Its reasoning for the same was:

• It is not correct to bifurcate STCG transactions on the basis of a holding period of 30 days and classify a part of the gain as STCG and a part as business income; 
   
• The tax payer had been regularly maintaining separate portfolios for investment and trading, and in the books, the shares that resulted in STCG had been treated as an ‘investment’, not as ‘stock-in-trade’. 
   
• In view of the consistent treatment adopted by the tax payer, the Tribunal felt the intention of the assessee at the time of acquiring the shares was for investment and not for trading. 
   
• Further, the fact that the tax payer had used his own funds and not borrowed funds to acquire the shares helped prove that he was buying and selling as an investor and not a trader. 
   
• The Tribunal also observed that on account of the transactions being dealt through the electronic system of the stock exchange, it has the potential to split a single order into numerous transactions. This gives an unrealistic figure of the number of transactions, which could not be a convincing factor to treat the transaction as business income. 
   
• In the said case, the tax payer’s quantum of gains from shares held for less than 30 days was less than half the gains on shares held for more than 30 days. This highlighted the tax payer’s intention to hold the shares for a longer period and to earn income of appreciation in the value of the shares and not merely earning profits on the short-period change in price of shares. 
   
• The tax payer’s case was also helped by his regularly earning dividend income from the share holding.

This decision would be very helpful for tax payers who may be churning their portfolios in the current market situation, to make gains or avoid losses. Most of the observations made by the Tribunal make it acceptable for an investor to reshuffle his portfolio over a short period to reduce the risk of loss of capital or income.

The writer is a certified financial planner