Questions with no easy answer

Some tax-related questions cannot be answered with a straightforward ‘Yes/No’. 

We will deal with one such question in this article: whether income from trading in shares should be classified as business income or capital gains? 

However, before answering this, we need to understand why classification is so important after all and how it impacts your taxes.

We are well aware that business income and capital gains are taxed (with exceptions, where applicable). So let’s understand a few basic differences between these two in short, without getting into the details:

Business income vs Capital gains

– Tax rates – Business income is generally taxed at slab rate (for individuals) or the standard rate (30%, 25% etc.) depending on the legal form of the taxpayer. On the other hand, capital gains are taxed at special rates (except for non-equity short-term gains), which are lower than the standard rates apply.

• Claiming expenses – Tax rules permit any expenditure (subject to exceptions explicitly provided) “…laid out or expended wholly and exclusively for the purpose of business..” to be deducted from business income. From capital gains, you can only deduct the expenses incurred for selling the asset. Courts have given judgements interpreting these rules (for both types of income) and decided whether a particular expense can be allowed as a deduction or not. We are not getting into those details here. It’s pertinent to note that Securities Transaction Tax cannot be claimed as a deduction from capital gains, but it is a permissible deduction from business income. 

• Setting off losses – While losses from business (non-speculative) can be offset against income from other heads (other than salaries), losses under capital gains cannot be offset against any other head of income.

– Audit and compliances – An audit is required only when a taxpayer has a business or profession. Certain other compliances, such as maintaining books of accounts etc., are applicable only when a business or profession exists. There are no such compliances for capital gains; you may retain the documents to back up the numbers in your ITR (as support in case of scrutiny etc.) 

Having understood a few basic differences, now let’s get familiar with the options available to a taxpayer in classifying trading income.

How to go about classifying

The question related to the classification of trading income as business or capital gains is pretty old. You might find it surprising that there are supreme court judgements on this issue, dating as far back as 1953. 

The income tax department has also issued many circulars and internal memos at regular intervals clarifying its position and providing guidance to tax officials. Two such instructions most relevant to our discussion are a circular issued on 29th February 2016 (for listed shares and securities) and a letter dated 2nd May 2016 (deals with unlisted shares).

Listed shares and securities:

The circular states that:

1. If the taxpayer chooses to treat the shares and securities as stock in trade, the profit will be considered business income irrespective of the holding period.

1. Regarding shares and securities held for more than 12 months, the taxpayer can offer the income as capital gains. Such an option, once exercised, cannot be taken back in subsequent years.

1. In other cases, income classification shall be based on guidance provided in circulars issued earlier and court judgments.

Understanding these clauses better:

If the shares are treated in books of account as inventory, then the income from the sale of such shares will be considered business income. The period of holding is irrelevant. A taxpayer can also opt to offer the income from shares held for more than 12 months as capital gains, and such an option has to be followed consistently. 

A combined reading of both the conditions also indicates that if the taxpayer chooses to offer income from the sale of shares held for more than 12 months as capital gains, he must follow it consistently irrespective of how he classifies (as inventory or investment) them in books in subsequent years. 

Also, as is evident from point C above, the circular attempts to reduce litigation and uncertainty but not eliminate it, in other words, the classification of income from listed shares and securities held for less than 12 months is still open for dispute (discussed later in the article).   

Unlisted Shares:

The income tax department has issued a letter to tax officers dated 2nd May 2016 instructing them to deal with gains from the sale of unlisted shares during assessments. As per the letter, income arising from the transfer of unlisted shares should be considered capital gains irrespective of the holding period. 

The letter further states that tax officers can use their discretion in the following situations (ignoring the general rule):

1. Where the genuineness of the transaction is ‘questionable’.
2. Transfer of unlisted shares is related to an issue pertaining to the lifting of the corporate veil. or
3. The transfer of unlisted shares is made along with control and management of the underlying business.

Unless a sale falls into the above three categories, income from unlisted shares is taxed under Capital Gains. If you wonder under what circumstances the genuineness of a transaction will be considered ‘questionable’, my guess is as good as yours.

Scope for ambiguity

As mentioned at the beginning of the article, the question on the classification of trading income does not have a straight answer. Though the circulars and letters issued by the department helps reduce the ambiguity, unanswered questions remain.

If a person sells listed shares/securities with a holding period of fewer than 12 months and wants to consider the gain as ‘capital gain’ for tax purposes, the tax officer can dispute that. As discussed earlier in the article, we need to rely on the principles evolved over a period of time-based on various old circulars issued by the department and court judgments. An office memorandum dated 13th December 2005, issued by CBDT, listed out the circumstances to be considered by tax officers while determining whether a person is a trader or an investor. A few of those (not copying the entire list here) are:

• The intention of buying the shares – Whether the shares are purchased with the intent to re-sell at a profit or for long-term appreciation and/or for earning dividends and interest.

• The scale of activity and frequency of trading.

• Whether trading is done out of own or borrowed funds: Chances of considering trading profit as business income are higher if trading is done out of borrowed funds. 

• The ratio of sales to purchases – Indicates the frequency again.

• Typical holding period of the securities.

• Time devoted to the activity. 

The list provided above gives you an idea of the various factors that can influence the case in favour or against the taxpayer. Having said that, the department understands and accepts that a taxpayer can have two portfolios, one for investments (securities are treated as capital assets) and one for trading (securities are treated as stock in trade). So, taxpayers with two different portfolios may have income from business and also capital gains.

In Summary

To conclude, there is no decisive answer, and each case has to be dealt with based on its merits. Small traders are generally not troubled by tax officers concerning the classification of trading income. 

Here is an extract from one of the circulars issued by the department which sums it up:

 “The assessing officers are further advised that no single principle would 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.”