Avoid churning your portfolio too much

The taxman may classify the gains from investment as business income, which could be taxed at 30%

Rising equity markets have seen the return of the individual investor. Since January, while the BSE Sensitive Index or Sensex has risen 26 per cent, retail investor participation, based on client-based gross market turnover, has increased 62 per cent.

Law professional Sagar Shah has been trying to cash in on the boom as well. He has made 15 per cent profits on his portfolio comprising large and mid-cap stocks. In the past five years, Shah 35, held only five large-cap stocks but has now added mid-caps, in his portfolio.

Tax experts warn that the likes of Shah might find themselves in trouble when they file returns next year. High churning of portfolios increases the number of transactions. This, in turn, attracts capital gains tax. “Those frequently buying and selling shares run the risk of being considered traders. So, the income from trading or business becomes business income, not income from investing,” says Kuldip Kumar, executive director – tax & regulatory services at PwC. When investment income is considered business income, it is taxed at the highest slab rate (30 per cent).

Therefore, Shah’s 15 per cent profit will become 10.50 per cent after a 30 per cent tax. While the taxman is unlikely to act on small gains, huge profits, say, Rs 5-10 lakh or above in a year, could be classified as business income and taxed accordingly, experts warn.

Says Nishant Shah, partner at Economic Laws Practice, “This is provided the shares are held as stock in trade, instead of investment, and valued as such. The other determining factors are the frequency of transaction and intention for which the activity is carried out, that is, to earn dividend or make profit.”

There is no fixed rule for distinguishing business income from investment income. It might vary from case to case, and on the number of transactions or amount of capital gains made. A lot depends on the sole discretion of the assessing officer looking into your case.

However, a Central Board of Direct Taxes (CBDT) circular dated June 15, 2007, says: “The substantial nature of transactions, 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 in the nature of 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.”

There are higher chances of portfolio churn and higher tax liability when investors take professional help to manage their money during market boom such as portfolio management services. Every portfolio management company has a defined, unique style of investing, varying with different schemes. Although such firms cannot guarantee returns, they churn portfolios that leads to higher tax incidence.

Loss of business income can be set off only with gains from other businesses, if any. Or, with income from other sources. If one cannot set off the business loss in one financial year, then s/he can carry forward the same to the next seven financial years, says Kumar of PwC.