In relation to share transactions, the question that frequently comes up, while determining tax liability on such transactions, is as to whether the shares in question were held as stock-in-trade or as an investment. The taxpayers need clear-cut, well-structured, specific instructions for investing in the capital market.
Tax liability on share transactions
1. Transfer [as defined under section 2(47)] of a capital asset [as defined under section 2(14)] resulting in capital gain may either be of long-term [as defined under section 2(29B)] or short-term [as defined under section 2(42B)] of the Income-tax Act, 1961 (‘the Act’).
The period of holding is the criterion for determining its nature : it is long-term capital gain, if asset has been held for more than twelve months prior to transaction and short-term capital gain, when it is held for a period less than twelve months.
Shares held as capital asset by the investor will be chargeable under the head ‘Capital gains’.
The tax liability in respect of long-term capital gains of shares, securities and units is elaborated in section 112 and such gain, if covered by securities transaction tax, is exempt under section 10(38) of the Act.
The taxability of short-term capital gain, as per section 111A of the Act, is at a flat rate of 20 per cent (as increased by the appropriate cess and additional surcharge).
Income from transfer of stock-in-trade by a trader is treated as business income under the head ‘Profits and gains of business or profession’, taxable at the rate of 30 per cent in addition to education cess and surcharge.
2. Tax treatment of share transactions has become debatable—whether the transaction involves transfer of stock-in-trade or it is from transfer of shares held as investment, resulting in business income or capital gain, respectively.
3. The tax authorities have set certain parameters to distinguish between stock-in trade and investment vide CBDT Instruction No. 1827, dated August 31, 1989 [F.No 181/1/89-IT(AI)]. Consequent upon the reduction of tax on short-term capital gain and total exemption of long-term capital gain by the Finance (No. 2) Act, 2004, with effect from April 1, 2005, some of the assessees are of the view that the tax authority treats their transaction as business income when the number of transactions is large in number. It could be attributable to lack of clarity and discretionary instruction. The supplementary instruction draft dated May 16, 2006 (F.No.149/287/2005-TPL), circulated by the CBDT fuelled further confusion in the minds of trader/investor, as the proposed instruction listed fifteen parameters, viz. :—
(i) Whether the purchase and sale of securities was allied to his usual trade or business/was incidental to it or was an occasional independent activity.
(ii) Whether the purchase is made solely with the intention of resale at a profit or for long-term appreciation and/or for earning dividends and interest.
(iii) Whether scale of activity is substantial.
(iv) Whether transactions were entered into continuously and regularly during the assessment year.
(v) Whether purchases are made out of own funds or borrowings.
(vi) The stated objects in the Memorandum and Articles of Association in the case of a corporate assessee.
(vii) Typical holding period for securities bought and sold.
(viii) Ratio of sales to purchases and holding.
(ix) The time devoted to the activity and the extent to which it is the means of livelihood.
(x) The characterization of securities in the books of account and in balance sheet as stock-in-trade or investments.
(xi) Whether the securities purchased or sold are listed or unlisted.
(xii) Whether investment is in sister/related concerns or independent companies.
(xiii) Whether transaction is by promoters of the company.
(xiv) Total number of stocks dealt in.
(xv) Whether money has been paid or received or whether these are only book entries.
The draft instructions also advise that no single criterion of the above fifteen items would be decisive and the total effect of all factors should be considered to determine the exact status of the activity.
This led to severe market reaction and the Finance Minister, Mr. P. Chidambaram was compelled to assure the investors not to panic, as the instructions would be finalized taking into view the concerns of the taxpayers.
4. In the landmark judgment of G. Venkataswami Naidu & Co. v. CIT  35 ITR 594, the Supreme Court observed that the presence of various factors is responsible for the inference whether transaction is in the nature of trade or not. It is not a matter of merely counting the number of facts and circumstances; what is important to consider is their distinctive character. In each case, it is the total effect of all relevant factors and circumstances that determines the character of the transaction.
If the purchase of share is solely and exclusively with the intention of resale at a profit, with no intention of holding or otherwise enjoying it or using it, then the nature would definitely be that of trade, concluded the Supreme Court.
This was further upheld in H. Mohmed & Co. v. CIT  107 ITR 637, where the Gujarat High Court observed that a stock-in-trade is something in which a trader or a businessman deals, whereas his capital asset is something with which he deals. Thus, the test of intention is also a very important factor. The High Court also held that selling outright in the course of the business activity and deriving income from exploitation of one’s own assets is the distinctive factor.
The Supreme Court, in Sardar Indra Singh & Sons Ltd. v. CIT  24 ITR 415, held that surplus resulting from sale of shares and securities constitutes business income. The High Court, in another important case, elaborated that any income arising from the sale of securities, closely connected with the main business, is business income.
Some of the other important cases are : State Bank of Hyderabad v. CIT  151 ITR 703/20 Taxman 123 (AP), Karam Chand Thapar & Bros. (P.) Ltd. v. CIT  82 ITR 899 (SC), CIT v. Associated Industrial Development Co. (P.) Ltd.  82 ITR 586 (SC) and AR.N. Ramaswami Chettiar v. CIT  48 ITR 771 (Mad.).
In a recent case the appellate Tribunal has held that volume or magnitude of transactions should not be the basis of considering such income as business income and that short-term capital gains, even if generated through a large number of transactions, would attract 10 per cent tax. The ITAT’s order, that the money an investor makes by exiting a stock within a year of purchase will be treated as ‘capital gains’ and not as ‘business income’, assumes significance as the department, normally, treats short-term capital gains as business income, if such gains are generated through a large number of transactions (i.e., sale and purchase of shares).
The above order would continue to be a guideline for the tax authorities and investors, until further notification from the Government in this regard.
5. India is poised for charting a high growth trajectory. The economy is buoyant. There is need for investors’ support to realize the dream. The role of administration is at the centre stage to provide fully transparent simple laws, guidelines for building confidence amongst the investors.
It is prudent and pragmatic to accept that investors operate in the stock market for gain with the element of high risk. There seems no scope for ‘to be determined on the facts and circumstances of the case’ or for (mis) interpretation by the tax authority and consultants, leaving room for corruption and litigation. The taxpayers need clear-cut, well-structured, specific instructions for investing in the capital market.