How is Investment in the Stock Market Taxed?

Have you thought about how investments are taxed?  Suppose you save your pocket money and buy something whose value will increase with time. You can sell this thing later at a higher price and earn a profit. Investment is just like this. You invest your money in the stock market or mutual funds and hope its value increases. Your investment is liable for taxation and a know-how of the same can help you to incur fewer risks.

Before we get into details of how to invest in the stock market, let us understand what capital gains are and how the taxes are calculated on different types of investments.

What Are Capital Gains?

Say you bought a table for a certain amount of money, and now you want to sell it. You obtain a profit if you sell it for more than the cost price. This increase in the value of the table is called capital gain. You subtract the cost price from the selling price, and you get the capital gains. 

In the stock market world, you can obtain capital gains from any type of investment. You might have to pay capital gains tax in some circumstances.

There are broadly two types of capital gains that you must know:

• Long-term capital gains (LTCG):

This occurs when you sell an asset after a holding period of more than 1 year.

• Short-term capital gains (STCG):

This occurs when you sell an asset when the holding period is less than equal to 1 year.

You must remember that if a relative gifts you a DIS (Delivery Instruction Slip), you don’t need to worry about capital gains tax as it is not taken as a transaction. (The Delivery Instruction Slip is used to transfer shares from one Demat account to another.) Note the people who are considered as relatives in this context - 

• Own brother or sister
• Own spouse
• Spouse’s sister or brother
• Lineal successor or ancestor
• Spouse’s lineal successor or ancestor
• The parent’s sister or brother
• Spouse of the people listed in points b) to f)

Let us now take a look at various types of instruments and how taxes are applied to them.

Stocks

Selling and buying shares are part and parcel of the stock market. As discussed above, when you get a profit from selling stocks at a higher price, you obtain capital gains. You must remember that capital gains tax is applicable here, both in long-term and short-term holding periods. Take a look at both in detail.

• Long-Term Capital Gains

To understand this, consider the following scenario. Suppose you bought shares of ₹100 on 22nd June 2022 and sold them for ₹140 on 9th October 2023. You made a capital gain of ₹40, and thus, you have to pay a 10% capital gains tax on this ₹40.

As discussed before, a holding period of more than 1 year incurs LTCG. The rate for this tax is none for the first ₹1 lakh and 10% when the amount is more than ₹1 lakh. This rate is applicable when the transaction of shares occurs in established stock exchanges.  You also need to pay security transaction tax (STT) for this. 

If an off-market transfer of shares occurs in a place outside an established stock exchange without paying STT, you have to pay 20% long-term capital gains tax. This is much higher than the 10% LTCG you have to pay normally.

• Short Term Capital Gains

This applies when the shares are sold in less than 12 months from the date of purchase. If you make a profit, you have to pay short-term capital gains, which are taxable at 15%. Let’s take an example. 

You bought shares of a company for ₹150 on 13th May 2020 and sold them for ₹167 on 24th December 2020. Since the holding period is less than 12 months, you have to pay STCG of ₹17 (₹167 - ₹150) at the rate of 15%.

An important point to remember is that you need not pay STCG if your income is less than ₹2.5 lakh per annum, which is the minimum tax slab. In such cases, there is no headache in calculating the short-term capital gains.

Bonds

Investing in bonds can be considered a good opportunity as you obtain capital gains and interest income. Both of these are taxable; hence, basic knowledge of the two is important.

• Taxation of Interest Income

The tax from interest income from bonds is filed under Section 56 (2) (ia) of the Income Tax Act. Your slab rate will be taken into consideration during the interest tax calculation from bonds. The interest income falls under the heading ‘Income from other sources”.

For example, suppose you earn an interest income of ₹20,000 from bonds, and your income falls under the tax slab of 20%. Here, you would have to pay a tax of ₹4000.

• Taxation of Capital Gains

When you sell bonds at a higher price than the purchasing price, the amount obtained is considered a capital gain.  The capital gains depend on two factors - i) whether the bond is listed or not, and ii) the holding period of the bond. 

Let us first take listed bonds. If the holding period of the listed bond is more than 1 year, the profit is taken as LTCG (long-term capital gain). You have to also know about indexation at this point. It is a method of lowering your LTCG to reflect the effect of inflation.

With indexation, the LTCG is taxed at 20%, while the rate is 10% without indexation. Short-term capital gain (STCG) takes place when the holding period is less than 1  year. The rate of taxation of STCG is your income tax rate.

In the case of unlisted bonds, if the holding period is more than 3 years, the gain is taken as LTCG. It is taxed at 10% if there is no indexation and 20% if indexation occurs.  STCG is considered when the holding period is less than 3 years, and the rate of taxation is your income tax rate.

Mutual Funds

Most of you want to invest in mutual funds as it is considered a relatively less risky investment. You must be aware of the taxation of mutual funds, and we are here to help you.

Similar to other types of assets, you get capital gain on mutual funds, but it is only obtained when you sell the asset. When you receive a part of the collected profits from the mutual fund house, it is known as a dividend. Both of these are taxable. You don’t need to sell your funds to receive dividends. Let us discuss these two in the context of equity funds and non-equity funds.

• Equity Funds

A few examples of these can be small-cap funds and large-cap funds. You will get long-term capital gains if you sell the mutual fund units in more than 1 year. The rate of LTCG is 10% if you receive capital gains of more than ₹1 lakh in a year. If you sell your units in less than 1 year, you get short-term capital gains, which are taxed at 15%. If the dividends you obtain are more than ₹10 lakhs, you have to pay a dividend tax of 10%.

• Non-Equity Funds

Some common examples of these can be debt funds, pension funds, and liquid funds. You already know about indexation. Long-term capital gains with a holding period of more than 3 years on non-equity mutual funds will yield a tax of 20% after indexation. The short-term capital gain with a holding period of less than 3 years is taxed at the same rate as your income tax slab. 

Before talking about the taxation of dividends, first, let us learn about DDT (Dividend Distribution Tax). It is the tax collected by the mutual fund house that states the dividends before they pay the amount to you (the investor). You had to pay a DDT of 28.84% on non-equity funds before the financial year of 2020-2021. It was abolished in 2020, and now the dividend is taxed at the same rate as your income tax. 

• ETFs

ETFs (Exchange-traded funds) are funds in which you can invest, like a share, on a stock exchange. The value of an ETF depends on the demand and supply in the market. Taxation of ETF is similar to stocks as you get LTCG and STCG depending on the holding period. We can divide the taxation type into two types.

• Equity ETF

ETFs, which you invest in equities, fall under this category. For long-term capital gains, the holding period must be more than 1 year. LTGC of more than ₹1 lakh is taxed at 10%, while any amount lesser does not yield any tax. For STGC of less than 1 year, you have to pay tax at 15% of the capital gains.

• Debt, Gold, and Other ETFs

Anything apart from equity ETFs falls under this bracket. A holding period of more than 3 years leads to LTCG with a tax of 20%. STGC occurs when the holding period is less than 3 years. The tax rate is the same as your income tax slab for STGC.

Wrapping Up

The stock market is an ever-changing landscape. It is vital to go through the basics time and again so that you can invest with a clear mind. Find out what type of investment suits you and how these are taxed. This can help you to gauge future market trends.