Tax – Dutch Uncles

Is Tax-loss Harvesting Strategy Beneficial?

Aakash Sharma — Mon, 20 Sep 2021 05:35:08 +0000

Tax-loss harvesting is a fundamental strategy for reducing tax payables and increasing capital gains by paying less in taxes. This strategy is provided for the benefit of investors and traders by the law to reduce the tax outgo on realised gains before the end of a financial year by booking a sell order on loss-making stocks.

One of the most critical aspects of tax-loss harvesting is: does it help increase return on investment? The simple answer is yes. As it helps you cut down the payable tax, it automatically enhances post-tax capital gains. Let us dive further into why it is a widely used practice in Indian securities markets and what can be the ups and downs of this tax-saving process.

The lack of wash sale rule in India

One factor that makes tax-loss harvesting profitable in India is the lack of legislation for wash sales. A wash sale proceeds when you sell a security at a loss and repurchase it or substantially identical security shortly before or after.

Technically, the wash sale rule is an American regulation that applies only to the United States securities market. Under the US wash sale rules, investors cannot use the loss accrued from a sale to set off their capital gains and reduce the tax liability.

Unlike the US, there is no provision for wash sales in India, which means that Indian investors and traders can use it to reduce tax losses without any consequences of reprimanding action by the tax authorities.

Example

Sample this. You hold a share of Vodafone-Idea. Suppose the share price drops from Rs. 100 (your buy price) to Rs. 60, meaning that you currently have an unrealised loss of around Rs. 40.

At the same time, you also hold a share of HCL Technologies. Assume that the share price of the HCL stock has risen from the buy price of Rs. 2,000 to around Rs. 2,100. Now, you have an unrealised profit of around Rs. 100. You subsequently decide to sell this share for a profit of Rs. 100.

Now, the profit of Rs. 100 is the capital gain on which you are required to pay tax. However, to reduce the tax liability, you also sell off the Vodafone-Idea share that you had for Rs. 60. This way, you can effectively make a loss of Rs. 40 on this transaction, and the tax will be levied on Rs. 60 instead of Rs. 100, thereby reducing your tax liability.

But then, you don’t wish to let go of the Vodafone-Idea share. And so, you simultaneously rebuy the share of Vodafone-Idea at Rs. 60. Such transactions are known as wash sale transactions.

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Reduced tax liabilities are undoubtedly the most prominent benefits of tax-loss harvesting. It not only helps investors but is also very helpful for traders.

Benefits of tax-loss harvesting for traders

For a stock market trader, every profit and loss in the market matters a lot due to the short-period nature of the trading activity. So if you have net realised business gain (short term capital gain, long term capital gain, Futures & Options profits), you are liable to pay up to 30% taxes on these gains.

However, you can deduct this tax liability by using tax-loss harvesting by realising the loss in trade transactions. With the sale of loss-making entities, which are giving either a short term or long term capital loss, you can reduce tax costs.

Once you sell the stock, you can either rebuy a similar stock instantly or wait for the stocks to go out from your Demat and then repurchase the same stock two days later.

Reorganise your portfolio

One of the best things about tax-loss harvesting is the ability to reorganise your portfolio. Reorganisation of the portfolio helps in improving the balance between wealth, profit and risk.

When indulging in refinancing via tax-loss harvesting, look at which holdings to sell or buy, and pay heed to the cost principle (the adjusted, initial purchase price). The cost basis will determine the capital gains or losses on each asset. The cost basis will determine the capital gains or losses on each asset. This method prevents you from selling only to realise a tax loss that may or may not fit your investment strategy.

Some downsides of tax-loss harvesting

Everyone wants to reduce tax payments on their hard-earned money and therefore look to tax-loss harvesting as a primary method. But assets that are down are not necessarily a bad thing in the stock market. If a down stock is the one that can provide diversification benefits and balance your long-term returns, such a stock strongly rings the buy bells.

Some experts consider tax-loss harvesting a fundamentally flawed approach as it involves selling loss-making stocks. Their sale can lead to the loss, although temporary, of important diversifiers in a portfolio for a relatively small tax saving.

Short versus long-term

As an investor, you need to look for long term benefits. And that sometimes includes buying into uncorrelated assets that have depreciated during a rapidly changing market regardless of the confidence one might have in the extension of equity increase.

Long-term losses on securities held for more than a year are generally netted against any long-term capital gains. In contrast, short-term losses on the sale of securities held for less than a year get applied to short-term gains, which are taxed at your higher ordinary income tax rate.

It is also essential to know that harvesting losses can add additional burdens, regardless of which tax bracket (10% or 15%) you belong to. To get the best possible benefits from your tax-loss harvesting, it is always advisable to consult an experienced financial advisor.

Since India does not have a wash sale rule, you can use wash sales transactions to limit your tax burden. However, you should carefully examine your overall returns because a careless strategy can lead to a net loss in the name of reducing tax burden through a wash sale.

In the end, the Indian financial markets and the laws regulating them give investors a fair chance to utilise the tax-saving benefit from tax-loss harvesting. Remember, the technique should be used as per your own goals, risk capability, financial knowledge, and with a greater understanding of the process.

The post Is Tax-loss Harvesting Strategy Beneficial? appeared first on Dutch Uncles.

What Is Tax-loss Harvesting?

Aakash Sharma — Sat, 18 Sep 2021 03:35:08 +0000

When you invest in equity-yielding financial securities like stocks and mutual funds, you make money in the form of capital gains over a specific period. The realisation of these capital gains, i.e., their encashment, becomes a taxable entity as it adds to your income stream. Capital gains are taxed according to the duration of your participation in the fund and market.

But there is one way that the law provides to reduce the tax burden on your investment gains; it is called Tax-loss harvesting. So, let’s delve into the details of tax loss harvesting and its various technical processes.

In tax loss harvesting, you sell your stocks/fund units at a loss to reduce your tax liability on capital gains. It is a method to offset the capital gains made on equity against the capital loss suffered to pay a lesser tax. Let us break down the process further, starting with the latest amendments in the law about the taxability of capital gains.

Tax amendments by the government on capital gains

Earlier, long-term capital gains from selling equity stakes and stock assets were completely tax-free for investors. However, amendments brought in by the 2018 union budget changed that. It got capital gains on the sale of listed shares and investment funds under tax purview.

Under the new rules, starting from April 1, 2018, long-term capital gains (LTCGs) above Rs. 1 lakh came under the 10% tax limit without indexing benefits. Indexing is used to change the purchase price of an investment to reflect the effect of inflation on it. A higher purchase price translates into lower profits, which means substantially lower taxes.

Indexing allows you to reduce the return on capital in the long run by reducing taxable income. But the new amends made such indexing benefits impossible. By law, short-term capital gains (STCGs) are taxed at the rate of 15%.

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As the taxation of capital gains on investments emerged, the law gave one option to investors for paying reduced taxes on such profits. This is where tax loss harvesting steps in - it can help you reduce the tax liability on both LTCG and STCG.

Tax loss harvesting

Tax loss harvesting is the method of trading financial security that undergoes a loss and helps you avoid some amounts of taxes, thus saving your money. By harvesting, i.e., realising losses, investors can offset their taxes on gains and income.

In tax loss harvesting, the shares must be withdrawn from the Demat account by a delivery sell transaction. You can purchase (or re-purchase) them the next day. The sold asset is substituted with a similar one, maintaining an optimal asset allocation and expected returns.

What does offsetting losses mean?

Offsetting in taxation processes means subtracting a capital loss from a capital gain and paying less tax. Simply put, the adjustment of losses against income or profit in a particular year is called set off.

For example, if you own two stocks and sell one at a profit and the other at a loss, you only pay capital gains tax on the difference between profit and loss. Losses not set off against income can be carried forward to subsequent years and used against income.

Usually, investors use tax loss harvesting for STCG because the tax rates on short-term capital gains are higher than long-term capital gains.

Realised versus unrealised gains (or losses)

A realised gain occurs when an investment is sold for a price higher than the buy price. Income from realised gains is subject to income tax. Depending on the time of holding, such profits are divided into short-term or long-term gains. Long-term gains are held for more than a year, while short-term gains are held for less than a year.

An unrealised gain is an increase in the value of investments that investors have not yet sold for money. On the other hand, an unrealised loss is a decrease in the value of an asset or investment that is held instead of its sale and loss realisation.

Example of tax loss harvesting

Suppose you earned Rs. 1 lakh in short-term capital gains this year. You will be taxed 15% or Rs. 15000 on this STCG. Assume that you currently have stocks holdings with an unrealised loss of Rs. 60,000. You can sell these stocks (and realise the loss) to reduce your net STCG to Rs 40,000

Realised gains – Realised loss = Net capital gain, i.e., Rs. 1,00,000 – Rs. 60,000 = Rs. 40,000.

As you realise the loss, you will have to pay 15% of Rs. 40,000, i.e., Rs. 6,000 as taxes. This will save you Rs. 9,000 in taxes. This method will let you harvest your losses and save on taxes – hence it is called tax-loss harvesting.

Mantras to remember while using tax loss harvesting

Now, you might wonder that your portfolio will reduce in size by realising the loss and selling the loss-making stocks. To counter this sale of stocks, you can place a simultaneous buy order of the same stocks or different stocks of a similar nature.

By using tax loss harvesting, you have realised the loss on the face. But with the simultaneous buy order, your portfolio will not get disturbed, and you will be able to save on taxes as well.

While setting off losses using tax-loss harvesting, you need to keep the following points in mind:

- You can only set off long-term capital loss against long-term capital gain. You cannot set off long-term capital losses against short-term capital gains.
- As an investor, you can set off short term capital loss against short term capital gain as well as long term capital gain.

Carry forward of losses

Unadjusted loss can still occur after making the necessary and permissible offset deals and adjustments. These unadjusted losses can be carried forward into future years to adjust for earnings. Different income origins have diverse rules regarding taking forward capital losses. You can move the loss forward for up to eight years after its assessment year.

The post What Is Tax-loss Harvesting? appeared first on Dutch Uncles.

Securities Transaction Tax (STT): All You Need To Know

Anju Nambiar — Thu, 09 Sep 2021 03:35:09 +0000

You can’t escape tax even in capital gains. Taxpayers are required to declare their profits on sales of stocks. Naturally, the government has stepped in to prevent tax evasion and to enforce tax outflow on financial market transactions.

What is Securities Transaction Tax?

Securities Transaction Tax (STT) is a tax accrued on the buying and selling of shares and other tradable securities of publicly listed companies. This tax is levied on listed securities including equity, derivatives, and units of equity-oriented mutual funds. STT is a turnover tax levied on the total consideration traded in shares. It’s a small tax but nonetheless significant for a retail investor. A financial transaction tax, it is similar to the Tax Collected at Source (TCS) and is applicable for all the recognised stock exchanges in India.

Purpose of STT

The main purpose of introducing STT was as an initiative to curb evasion of tax on capital gains or profits for transaction on securities. It was also meant to be a clean and efficient means of extracting taxes within the finance market. STT is governed under the Securities Transaction Tax Act which was introduced during the Union Budget of 2004. It was aimed at replacing the low tax on Short-Term Capital Gains (STCG) and 0 tax on Long-Term Capital Gains (LTCG) on equities. The initial tax bracket was too high for brokers and the trading community and a request for reduction was subsequently accepted by the government.

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STT is a turnover tax levied on the total consideration traded in shares.

How is it levied?

STT is added to the stock price during a transaction and is auto-added to the transaction price. The STT must be collected by a recognised stock exchange or by a prescribed person in the case of mutual funds. In the case of an IPO, it must be collected by the lead merchant banker. The STT collected is payable to the government by the 7th of the following month. Tax evasion is near impossible since the broker or the asset management company deducts it at the source.

Securities that comes under the ambit of STT

The securities defined under the Securities Contracts (Regulation) Act, 1956 that come within the scope of STT include the following:

Marketable securities including shares, scrips, stocks, bonds, debentures, and debenture stocks.
Derivatives
Government equity securities
Equity oriented units of Mutual Funds
Security rights
Securitized debt instruments

STT calculation

STT is calculated as a percentage of the unit value of the security being traded and can be anywhere between 0.001% to 0.2%.

Let’s see how STT is calculated for Intraday Trades. For the sell side of the transaction at 0.025%, let’s assume that a trader purchased 100 shares of HDFC at INR 1000 each on a Monday morning and sold them off at INR 1005 in the evening. A simple STT calculation will be

STT = (1005 X 100 X 0.025) / 100 = INR 25.125.

About STT Tax Rate

The rate of STT levied may vary depending on several factors including the type of security traded and on the type of transaction (purchase or sale). The tax rates are decided by the Central Government. Off-market, commodity, and currency transactions do not accrue tax. Here is a breakdown of the varying tax rates levied on various transactions.

Although STT’s tax quantum is a relatively small amount, it contributes to a high transaction cost and may impact the profits of investors. Apart from STT, two other taxes are imposed on stock market investors namely, the Capital Gains Tax and the Dividend Distribution Tax. Although the investments in the stock and share market cannot be predicted, investors are still required to pay taxes even if they incur losses.

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