Taxation of Shares & Securities

Transactions in stock market is becoming common day by day with many avenues being open for public at large to explore to invest & trade. As I write this today, 400 crores shares & securities have been traded on NSE. However, the start of this Indian share market is very interesting & dates back to 1875. What we know today as Bombay Stock Exchange (‘BSE’) was known as “Native Share and Stock Broker’s Association.” This was the first ever stock exchange in Asia established by a cotton merchant Premchand Roychand which is located on Dala Street today which is named after Roychand’s brokerage firm – the Dalal Street Investment Corporation.

Post that era, today we see Indian Share Market booming day by day with NSE, established in 1994, by the Indian Government to usher in transparency to country’s capital market, standing on 8th position globally within stock- markets with market capitalisation of $3.5 Trillion as of August, 2023. It was stated in the SEBI study that traders in India jumped by 6.5 times in 3 years i.e., between FY 19-FY 22.

In this context, it has become imperative to thoroughly understand various aspects regarding the shares & securities. We, through this series shall cover pertinent topics such as capital gain & consequent considerations, discussion regarding nature of treatment of shares & it’s tax implications, ESOPS, Angel Tax, Buy-back of shares, Taxation of Derivatives, Speculative transactions, Mutual Funds & Debt Instruments.

Taxation of Securities in India

For identifying the tax amount due on sale of securities one must peruse the following:

Nature of security i.e., equity or debt & whether those are listed on a recognised stock-exchange or otherwise
Period of holding
Nature of Treatment i.e., as a capital asset or stock-in-trade
Cost of acquisition
Any other special provision that may apply

As we start with the series, we shall cover basic provisions that affect the taxation of securities & one pertinent issue i.e., taxation of derivative transactions in this 1st article of the series.

Nature of Securities in India

Equity Securities

Equity securities include shares and stocks of a company. A company’s capital is divided into various small units and each such unit is a share. The monetary value of these shares is called equity. Thus, equity securities represent the ownership of a company. This means that if one owns the share of a company, then he or she becomes one of the shareholders or owners of that company.

The Equity Securities include shares of a listed or unlisted entity, equity oriented mutual funds, preference shares.

Debt Securities

Debt securities are borrowed funds of a company that are used to raise capital from the public. These instruments are issued by a company in the form of bonds, debentures, treasury bills etc. to lenders for a certain period in exchange of an amount.

Debt Securities include Bonds, Debentures, Commercial Paper etc.

Period of Holding

It is pertinent to classify the securities held as long-term or short-term as the rate of taxation differs depending on the classification.

Section 2(42A) of the Income-tax Act (‘the Act’) defines short-term capital asset which consequently defines long-term capital asset wherein period of holding is longer than defined in section 2(42A) of the Act.

Particulars	Minimum Period of holding for classification as Long-term Asset</strong >
Security (other than a unit) listed in a recognized stock exchange in India or a unit of the Unit Trust of India established under the Unit Trust of India Act, 1963 (52 of 1963) or a unit of an equity- oriented fund or a zero- coupon bond	> 12 months
Share of a company (not being a share listed in a recognised stock exchange)	> 24 months
Any other Asset	> 36 months

For the purposes of the 2(42A), the expression “security” is said to have the meaning assigned to it in clause (h) of section 2 of the Securities Contracts (Regulation) Act, 1956 (42 of 1956) which states to include within the ambit of securities – shares, scrips, stocks, bonds, debentures, debenture stock or other marketable securities of a like nature in or of any incorporated company or other body corporate.

Further, the explanation to clause 2(42A) of the Act, a few peculiar cases have been addressed:

in the case of a share held in a company in liquidation, the period subsequent to the date on which the company goes into liquidation shall be excluded.
in the case where any security becomes the property of the assessee on distribution of assets on the total or partial partition of a HUF, under gift or a will, the holding period of the previous owner shall be considered.
in the case of conversion of a stock-in trade to capital asset, the period shall be reckoned from the date of such conversion
in the case of bonus or right shares, the period shall be reckoned from the allotment of such shares
in case of rights to subscribe to any financial asset, the period of holding shall be from the date of offer of such right by the company making such offer
in case of capital asset being sweat equity shares or ESOPs, the period shall be reckoned from the date of allotment or transfer of such shares
in case of equity shares converted from preference shares, the period for which the assessee held preference shares shall be included
in case of a unit of a business trust, allotted to the assessee after conversion of shares of a Special Purpose Vehicle, the period of holding shall include period for which such shares have been held by the assessee.
in case of shares of amalgamed company, the period shall be reckoned from the date of allotment of the amalgamating company.
in case of shares allotted pursuant to demerger of a company, the period shall be reckoned from the date of allotment of the demerged company.

Shares & Securities– Stock-in Trade or Capital Asset?

Shares & Securities can be held as stock-in trade or capital asset & the nature of holding affect the nature & rate of taxation. Thus, it is very crucial to determine whether the nature of holding of shares & securities. However, there is no specific guidance in the Income-tax Act as to what shall be the treatment of the shares under different circumstances. The litigations on such topic largely revolved around the intention at the time of purchase which saw no full stop. Thus, CBDT issued various circulars & clarifications for dealing with such issue & in order to minimise the litigations.

The first instruction issued in the matter was Instruction No. 1827, dated 31st August, 1989 where CBDT brought to the notice of the Assessing Officers that there is a distinction between shares held as investments (capital asset) and shares held as stock-in-trade (trading asset). However, in the light of various judicial pronouncements, the CBDT updated the above instructions where in it sighted ratio laid down by the Hon’ble Apex Court:

Commissioner of Income Tax (Central), Calcutta v. Associated Industrial Development Company (P) Ltd (82 ITR 586) which held that “Whether a particular holding of shares is by way of investment or forms part of the stock-in-trade is a matter which is within the knowledge of the assessee who holds the shares and it should, in normal circumstances, be in a position to produce evidence from its records as to whether it has maintained any distinction between those shares which are its stock-in-trade and those which are held by way of investment.”

Further, it sighted the ratio laid down by the Hon’ble Apex Court In the case of Commissioner of Income Tax, Bombay v. H. Holck Larsen (160 ITR 67), wherein it was observed that “The High Court, in our opinion, made a mistake in observing whether transactions of sale and purchase of shares were trading transactions or whether these were in the nature of investment was a question of law. This was a mixed question of law and fact.”

Further, it sighted the principals culled out by the AAR (288 ITR 641) following the above ratios laid down by the Supreme Court.

“Where a company purchases and sells shares, it must be shown that they were held as stock-in-trade and that existence of the power to purchase and sell shares in the memorandum of association is not decisive of the nature of transaction;
the substantial nature of transactions, the manner of maintaining books of accounts, the magnitude of purchases and sales and the ratio between purchases and sales and the holding would furnish a good guide to determine the nature of transactions;
ordinarily the purchase and sale of shares with the motive of earning a profit, would result in the transaction being trade/ adventure in the nature of trade; but where the object of the investment in shares of a company is to derive income by way of dividend etc. then the profits accruing by change in such investment (by sale of shares) will yield capital gain and not revenue receipt”

It was also advised to the Assessing officers no single principle should be decisive and the total effect of all the principles should be considered to determine whether, in a given case, the shares are held by the assessee as investment or stock-in-trade.

Further, CBDT also emphasised that it was possible for a taxpayer to have two portfolios i.e., an investment portfolio comprising of securities which are to be treated as capital assets and a trading portfolio comprising of stock-in-trade which are to be treated as trading assets. Where an assessee has two portfolios, the assessee may have income under both heads i.e., capital gains as well as business income.

The ratio laid down by the case Gopal Purohit by the Hon’ble Mumbai ITAT (122 TTJ 87) & affirmed by Hon’ble Bombay High Court confirms that the assessee can be engaged in two activities i.e., that of investing & trading in securities simultaneously.

In the present case the assessee had treated non- delivery-based transactions as business activity and delivery-based transactions as an investment activity. Consequently, the AO held that the assessee was engaged in only one activity, i.e., activity of earning profit through sale and purchase of shares or purchase and sale within short period or long period and the expenses incurred thereon were also inseparable and, hence, the entire profits arising out of such transactions were to be assessed as income from business and profession and consequently, he disallowed the claim of the assessee.

The Hon’ble Mumbai ITAT held that here should be uniformity in treatment and consistency under the same facts and circumstances and it was already found that facts and circumstances were identical in the previous year & allowed the claim of the assessee. Further, it also stated that Further, there is no material to show that these shares in the investment portfolio were also traded in the same and like manner as those which were in stock-in- trade portfolio & there is no material brought in by the Revenue to show that separate accounts of two portfolios are only a smoke screen and there is no real distinction between two types of holdings.

On appeal by the Revenue, the Hon’ble Bombay High Court held that the Tribunal has correctly applied the principle of law in accepting the position that it is open to an assessee to maintain two separate portfolios, one relating to investment in shares and another relating to business activities involving dealing in shares.

However, to further bring clarity on the issue, CBDT issued Circular No. 6/ 2016 dated 29th February 2016 as disputes continued to exist even after issuance of instructions & circular as above as taxpayers found it difficult to prove the intention in acquisition of shares or securities. Thus, even after acknowledging that there no universal principal in absolute terms can be laid down to decide the character of income from sales & securities, CBDT instructed its Assessing Officers to consider that when:

The assessee itself, irrespective of the period of holding the listed shares & securities, opts to treat them as stock-in- trade, any income arising out of transfer of such shares or securities would be treated as business income.
In respect of listed shares & securities held for a period of more than 12 months immediately preceding the date of its transfer, if the assessee desires to treat the income arising from the transfer thereof as Capital Gain, the same shall not be disputed by the Assessing Officer. However, this stand, once taken by the assessing officer in a particular assessment year, shall remain applicable in subsequent assessment years also & the assessee shall not be allowed to adopt a contrary stand in this regard in subsequent years.

However, it was also clarified that the aforementioned shall not apply to transactions in shares & securities were genuineness of the transaction itself is questionable such as bogus claims of LTCG/ STCG or any other sham transaction.

Further, for unlisted shares, CBDT issued a letter dated 2nd May, 2016 vide F.No.225/12/2016/ITA.II wherein it was communicated that for determining the tax- treatment of income arising from transfer of unlisted shares for which no formal exists for trading, the gains would be considered under Capital Gains irrespective of period of holding.

Treatment on Conversion of shares

Conversion from capital asset into stock-in trade –

Earlier, when any capital asset, being securities, were converted to stock-in trade, difference between the cost & market value on the date of conversion escaped taxation. In view to address this issue, section 2(47) of the Act & section 45 of the Act were amended effective from Assessment year 1985-86 pursuant to which the conversion of capital asset into stock-in trade was included in the definition of transfer.

Further, for the purpose of computation of capital gains, section 45(2) of the Act provides that the FMV of the asset on the date of conversion shall be deemed to be the full value of consideration & the incidence of such tax is postponed to the year in which such converted stock-in trade is sold.

Thus, though the transfer takes place in the year in which conversion takes place, tax is payable only in the year when such stock-in trade is sold. Further, it is also required to be considered that the benefit of indexation shall be only available till the year of conversion as conversion is deemed to be transfer. Also, for the period to be reckoned as period of holding, it would be safe to consider the period till the date of conversion as thereafter the securities ceases to be capital asset & partake the nature of stock-in trade.

Conversion from stock-in trade into capital asset –

Finance Act 2018 brought in several amendments which gave a much-required clarity on such conversion.

Finance Act 2018 inserted clause (via) to section 28 to provide that the FMV of the inventory as on the date of conversion shall be charged to tax under PGBP & clause (xiia) to section 2(24) was inserted to include such FMV in the definition of income.

On a plain reading of these newly inserted provisions, it seems that these amendments wrongly tax the entire FMV without considering the costs. However, for all practical purposes & as per natural course of taxation law, it is only the profits arising out of such transaction i.e., the difference between the FMV as on the date of conversion & the cost of purchase shall be taxed under PGBP.

Further, section 49 of the Act was amended to provide that such FMV shall be the cost of acquisition for the purpose of computation of capital gains in the event of sale of such assets & 2(42A) was amended to provide that period of holding for the purpose of classification of such asset into short-term or long-term shall be reckoned from the date of such conversion of stock-in trade to capital asset.

Income from Derivatives

Proviso to the Section 43(5) of the Act specifies transactions which shall not to be deemed as speculative transaction. Clause (d) to such proviso includes an eligible transaction in respect of trading in derivatives referred to in clause (ac) of section 2 of the Securities Contracts (Regulation) Act, 1956 (42 of 1956) carried out in a recognised stock exchange.

Further, clause (ac) of section 2 of the Securities Contracts (Regulation) Act, 1956 (42 of 1956) states:

(ac) “derivative” includes—

(A) security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security;

(B) a contract which derives its value from the prices, or index of prices, of underlying securities;

Thus, trading in options & futures shall be regarded not as a speculative income but shall be taxed as Profits from Business similar to non- speculative transactions. Thus, it is imperative to calculate turnover of such transactions to ascertain the applicability of Audit under section 44AB of the Act as well as whether such assessee is entitled to avail the benefits of provisions of section 44AD of the Act. In view of the same, the ICAI in its Guidance Note has clarified that the turnover for such transactions shall include the total of favourable and unfavourable differences shall be taken as turnover.

Thus, as per revised provisions of the Act, the eligible business of trading into Futures & Options can avail benefit of section 44AD if such turnover does not exceed 3 crores where the amount or aggregate of the amounts received during the previous year, in cash, does not exceed five per cent of the total turnover or gross receipts of such previous year

Further, if the assessee’s turnover is below 10 crores & (a) aggregate of all amounts received including amount received for sales, turnover or gross receipts during the previous year, in cash, does not exceed five per cent of the said amount; and (b) aggregate of all payments made including amount incurred for expenditure, in cash, during the previous year does not exceed five per cent of the said payment, the assessee is not required to get its books audited.

Thus a few pertinent questions that arise as under:

1. What is the applicability of audit of a person who has earned income from Futures & Options for the 1st time & has earned profits less than 6% but more than minimum amount chargeable to tax & has turnover less than 3 crores? Whether such person be required to get its books audited under clause (e) of section 44AB? For such person earning income from Futures & Options for the first time, it would be safe to state that provisions of section 44AD(4) of the Act would not apply to the such person as he has not availed benefit of section 44AD for such business. Thus, in such case, he would be liable to maintain books of accounts & may file his return without getting the books audited.
2. What is the applicability of audit of a person who has earned income from Futures & Options for the 1st time & has earned profits less than 6% but more than minimum amount chargeable to tax & has turnover less than 10 crores but more than 3 crores? Whether such person be required to get its books audited?

However, an interesting anomaly seen here is that if for a particular previous year, the assessee availed the benefit of provisions of section 44AD & for subsequent year, the profit of the assessee falls below 6% but is higher than income chargeable to tax, the assessee is required to get its books audited under clause (e) to section 44AB as provision of section 44AD(4) apply to the assessee. However, such person, when its turnover is above 3 crores but less than 10 crores & considering the fact that all transactions is respect of trading in listed derivatives take place through banking channels, is not required to get the books audited.

Conclusion

As we discussed at length basic provisions that affect the nature of taxation of shares, there are many more such pertinent issues such as taxation of Speculative Transactions, Mutual Funds, Debt Instruments, ESOPs, Angel Tax, Buy-back of shares which will be covered in upcoming articles of the series.