How Do Stock Traders Save Taxes on Trading in India?

Types of taxes applicable on trading in India

In the context of trading in India, there are several important classifications that play a significant role in how income generated from trading activities is taxed. These classifications include Long-Term Capital Gains (LTCG), Short-Term Capital Gains (STCG), Speculative Income, Non-Speculative Income, Dividend Income, and Capital Gains on Unlisted Shares.

LTCG applies when shares are held for more than a year, while STCG comes into play when shares are sold within a year. Speculative income relates to trading activities that involve high uncertainty and short-term profit-seeking. Non-Speculative Income encompasses trading activities that involve actual delivery of goods or securities. Dividend income is taxed in the hands of investors, with tax rates varying depending on the recipient's category. Capital gains on unlisted shares are taxed differently based on whether they are held as investments or as part of a business. These classifications are essential for determining tax obligations and exemptions in the trading world.

Tax saving strategies for stock traders in India

The experts at TU have shortlisted the following tax saving strategies applicable to stock traders and investors in India:

Investing in ELSS

ELSS is a category of mutual funds that primarily invests in equity and equity-related instruments. It is specifically designed to help investors save on taxes while also providing the potential for capital appreciation. However, these investment vehicles come with a lock-in period, meaning you cannot redeem your investment for a specific duration, i.e., three years.

Tax benefits of ELSS

• Section 80C Deductions - ELSS investments are eligible for deductions under Section 80C of the Income Tax Act. Investors can claim a deduction of up to Rs. 1.5 lakhs annually on their taxable income. This means that if you invest the maximum allowed amount of Rs. 1.5 lakhs in ELSS, you can reduce your taxable income by that same amount. For example, if your total taxable income is Rs. 8 lakhs and you invest Rs. 1.5 lakhs in ELSS, your taxable income will be reduced to Rs. 6.5 lakhs

• Potential for Wealth Creation - While ELSS investments offer tax benefits, they also have the potential to generate substantial returns over the long term. Since ELSS primarily invests in equities, it allows investors to benefit from the growth potential of the stock market

Extending the investing horizon

Long-term investing acts as a prudent tax-saving strategy for stock traders in India. This approach offers several advantages, including reduced tax rates on Long-Term Capital Gains (LTCG) and tax exemptions on a portion of the gains.

Tax benefits of buy and hold strategy

• Reduced Tax Rate - Holding investments in stocks, mutual funds, or other capital assets for more than one year qualifies them as long-term investments. Long-term investments benefit from a significantly lower tax rate on capital gains. As of the current tax laws in India, LTCG is taxed at a rate of 10.4%, including cess, for amounts exceeding Rs. 1 lakh. This rate is substantially lower than the tax rate for short-term capital gains

• Tax Exemption on Rs. 1 Lakh - Another key advantage of long-term investments is the exemption available on the first Rs. 1 lakh of LTCG. This means that if your long-term capital gains from stock investments are less than Rs. 1 lakh, they are entirely tax-exempt. This exemption provides a buffer for small investors and encourages long-term wealth creation

Investing in Residential Property

This strategy is more suited to traders with substantial Long-Term Capital Gains (LTCG). It allows you to claim a tax exemption on your LTCG by reinvesting the sale proceeds in residential property.

Tax benefits of investing in residential property for stock traders

Under Section 54 of the Finance Act, traders in India can avail themselves of tax exemptions on LTCG by following these key provisions:

• The trader must invest the entire sale proceeds from your stock investments into a residential property

• The new residential property must be purchased either one year before the sale of shares or within two years from the date of the sale. In case they plan to construct a residential property instead of purchasing one, the construction must be completed within three years from the date of the sale

• Once they’ve invested in the residential property, they need to retain ownership of the residential property for a minimum of three years. Failure to do so may result in the exemption being revoked

Example

Suppose you sold stocks with a profit of Rs. 30 lakhs. If you don't utilize the provisions of Section 54 and simply calculate the LTCG tax based on the applicable rate of 10.4%, your tax liability would be somewhere around Rs. 3,01,600. Here’s how this calculation is done.

However, by investing all profits (Rs. 30 lakhs) in a new residential house within one year from the date of the stock sale, a trader can save the entire tax liability of Rs. 3,01,600. This is a substantial tax-saving benefit that can significantly enhance your wealth.

Reinvesting in notified government bonds or securities

Reinvesting in notified government bonds or securities is a tax-saving strategy that can be particularly beneficial for traders who have already utilized the Section 54 exemption by investing in a residential property. This strategy allows you to defer the tax liability on your Long-Term Capital Gains (LTCG) by reinvesting the proceeds in government-notified bonds or securities.

To qualify for this tax-saving strategy, you must invest in the notified bonds or securities within six months from the date of the stock sale. Ensure that you meet this time frame to avail yourself of the benefits.

Maximum investment limit

The maximum allowable investment in government-notified bonds or securities is Rs. 50 lakhs at a time. It's important to note that this investment limit applies twice a year. Therefore, if you have substantial LTCG, you may need to stagger your investments to stay within the limit.

Example

Suppose you sold stocks with a profit of Rs. 20 lakhs, and you have already utilized the Section 54 exemption by investing in residential property. If you don't opt for the notified bonds strategy, you would be liable to pay LTCG tax at the applicable rate of 10.4%, which amounts to Rs. 2,08,000. Here’s how this calculation is done.

However, by reinvesting the LTCG proceeds of Rs. 20 lakhs in government-notified bonds or securities within six months, you can defer the LTCG tax liability. This means you won't have to pay the tax immediately, providing you with liquidity and the opportunity to earn returns on your investment. Keep in mind that while your LTCG tax is deferred, the interest income generated from government-notified bonds or securities may be taxable.

Setting off capital gains

Under this tax-saving strategy, if you have accrued short-term capital gains from selling shares within a period of 6 months, you can offset these gains against any short-term capital losses you may have incurred from different forms of investment. In essence, you can use your losses from one investment to reduce the tax liability on your gains from another investment.

By offsetting capital gains with capital losses, you effectively reduce your taxable income. This leads to lower tax liability, saving you money on your overall tax payments. It's a way to make the most of your investments and minimize your tax burden.

Example

Consider a trader who has accrued short-term capital gains of Rs. 100,000 from selling shares within 6 months. Additionally, they have incurred short-term capital losses of Rs. 50,000 from another form of investment, such as debt securities or mutual funds, within the same financial year.

In this scenario, they can set off the short-term capital losses of Rs. 50,000 against the short-term capital gains of Rs. 1,00,000. Here's how it will affect their tax liability:

• Short-Term Capital Gains - Rs. 1,00,000

• Short-Term Capital Losses - Rs. 50,000

By setting off the capital losses against the capital gains, their taxable income is effectively reduced:

• Taxable Income = Short-Term Capital Gains - Short-Term Capital Losses

• Taxable Income = Rs. 1,00,000 - Rs. 50,000 = Rs. 50,000

The tax liability is calculated based on the reduced taxable income, resulting in lower taxes owed for the trader.

Carry forward of losses

As per Indian tax laws, capital losses can be carried forward to subsequent assessment years to offset capital gains, thereby reducing tax liability. This provision offers significant tax planning opportunities for individuals, particularly for stock traders and investors.

It's crucial to note that capital losses can only be set off against gains from the same class of investment. In other words, losses from the sale of stocks can be used to offset gains from stocks, and losses from other asset classes can offset gains from those same asset classes.

Investing in tax-efficient investment instruments

This table provides an overview of different tax-saving instruments, their return types, tax exemption limits on principal amounts, and their respective lock-in periods. Remember to review the specific terms and conditions of each investment option before planning.

Indexation

Indexation for taxes is the act of revising the tax basis of an asset based on purchasing power changes. Understanding how it works can be beneficial in reducing tax liability, especially when it comes to debt mutual funds.

Example

Suppose you buy a debt mutual fund for Rs. 2,500 and sell it for Rs. 3,500 after holding it for 6 years. Here’s how the Long-Term Capital Gains (LTCG) on the debt fund will be calculated after accounting for indexation:

• Calculate the nominal profit
  Profit = Selling Price – Buying Price; so
  Profit = Rs. 3,500 – Rs. 2,500 = Rs. 1,000

• Gather indexation figures
  Let's assume the corresponding index rate is 150 on the purchase date and 170 on the selling date

• Calculate the indexed cost of acquisition
  Indexed Cost = (Cost of Acquisition) * (CII of the Year of Sale) / (CII of the Year of Purchase); so
  Indexed Cost = (Rs. 2,500) * (170 / 150) = Rs. 2,833.33 (rounded to the nearest decimal)

• Calculate Capital Gain after Indexation
  Capital Gain = Selling Price – Indexed Cost; so
  Capital Gain = Rs. 3,500 - Rs. 2,833.33 = Rs. 666.67 (rounded to the nearest decimal)

Using indexation, your Long-Term Capital Gain on the debt fund is Rs. 666.67, which is significantly lower than the nominal profit of Rs. 1,000. This reduced capital gain will be subject to tax, resulting in lower tax liability.

Trading stocks as a business entity

When you trade stocks as an individual, any profits earned from these transactions are typically categorized as capital gains. Capital gains tax is applied directly to the profits made on the sale of assets, and the tax rate depends on whether it's a short-term or long-term gain. However, if you establish a business entity for your stock trading activities (such as a proprietary trading firm, partnership, or corporation), the income generated from your trading activities is treated as business income, which is calculated differently from capital gains. It considers not only the revenue, but also various deductible expenses associated with running the trading business.

Deductible expenses

As a business entity, you can deduct various expenses incurred to earn income from trading. These expenses may include:

• Rent or lease payments for your trading space or office

• Depreciation of equipment and assets used for trading

• Salaries or compensation paid to employees or traders

• Telephone bills and internet expenses related to your trading operations

• Costs associated with research and data subscriptions

• Office supplies and other operational expenses

Tax benefits of trading stocks through a business entity

As a business entity, the ability of deducting expenses reduces your taxable business income. This means you only pay taxes on the net income after deducting all allowable expenses. Lower taxable income can lead to a reduced tax liability compared to paying capital gains tax on the entire trading profit.

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