Taxing times: Understanding the tax implications of demat account transactions

While many brokerage firms offer the convenience of opening a demat account at zero cost, maintaining and transacting within these accounts come with expenses that retail investors must be aware of. Engaging in stock trading—whether purchasing or selling—incurs fees, and understanding the financial responsibilities tied to a demat account is essential for investors.

The distinct taxes associated with financial asset transactions are explained here, including capital gains taxes, the securities transaction tax (STT), and a brief explanation of how capital losses can be used to lower tax liabilities. 

1)       Capital gains 

Capital gains tax is imperative for any investor selling financial assets, such as stocks, indices, bonds, or mutual funds. The tax is based on the difference between the asset’s selling and original buying prices. The duration for which an asset is held determines whether the gain is classified as short-term or long-term. Each classification has distinct tax implications. 

Short-term capital gains (STCG)

STCG apply when assets are sold within a year of purchase. For most financial assets like stocks, if they are held for less than 12 months, any gains earned are taxed at a higher rate than long-term gains. For equity-linked assets, such as mutual funds and stocks, STCG is taxed at 20%, while other assets might incur different rates depending on the investment type. 

For example, if an investor purchases shares of ₹1 lakh and sells them nine months later for ₹1.20 lakh, they would make a gain of ₹20,000. This gain would be taxed at 20%, resulting in a tax liability of ₹4,000. It is crucial to note that this rate applies just to gains from assets held for less than a year, particularly in the case of equity and equity-linked funds.  

Long-term capital gains (LTCG)

LTCG are gains from the sale of assets that have been held for over 12 months. LTCG benefits from lower tax rates to encourage long-term investment. Note that long-term gains on equity investments are taxed at 12.50% if the gains surpass ₹1.25 lakh in a financial year. 

For instance, if an investor makes a profit of ₹2 lakh after holding stocks for over a year, the first ₹1.25 lakh is exempt from tax. The remaining ₹75,000 will be taxed at 12.50%, resulting in a tax liability of ₹9,375. These favourable tax rates make holding assets for more than a year a tax-efficient strategy for long-term investors.   

2)       Security transaction tax (STT)

The STT was introduced in 2004 to generate revenue from stock market transactions and to add transparency to the trading process. STT is levied on the purchase and sale of securities like equity-oriented mutual funds, derivates, and stocks. 

Both buyers and sellers of securities are subject to STT, which is computed as a small percentage of the overall transaction value. For example, when an investor purchases or sells shares on the stock exchange, an STT charge is applied depending on the trade type, whether it is a delivery-based equity trade or an intraday transaction. 

Note that equity delivery trades attract an STT of 0.1% on both the buy and sell side, while intraday trades may have a lower rate on just the sell side. 

Futures and Options (F&O) trades are subject to STT, and starting October 1, 2024, the STT rate for F&O will be increased to 0.02% from 0.0125% and to 0.1% from 0.0625%, respectively, following the announcement in the Union Budget 2024.

This increase in STT for F&O trading could significantly impact traders who engage in high-volume trading, as their tax liabilities on these transactions will double. 

3)       Capital loss and tax planning

A capital loss takes place when an investor sells a financial asset for less than the price they originally paid for it. These losses can arise from distinct factors such as market downturns, poor investment decisions, or changes in the value of the underlying assets. However, capital losses offer a silver lining; they can be used to offset capital gains, lowering the thorough tax liability. 

Capital losses are divided into two types, depending on the duration for which the asset is held:

Short-term capital loss: Occurs when the asset is held for one year or less and sold at a loss. 

Long-term capital loss: Occurs when the asset is held for over one year before being sold at a loss.  

Offsetting gains with losses

One of the crucial strategies in tax planning involves using capital losses to offset gains. For instance, if a retail investor makes a ₹50,000 gain from the sale of one asset but incurs a loss of ₹30,000 from another asset in the same financial year, the capital loss can be used to lower the taxable capital gain. In this scenario, the net taxable gain would be ₹20,000.

Moreover, if overall capital losses surpass capital gains in a given year, the excess losses can be carried forward to future years. Capital losses can be carried forward for up to 8 years.  

Ending note

Understanding the costs linked with maintaining a demat account and the tax obligations on trading is crucial for effective financial planning. Taxes like capital gains and STT play an imperative role in one’s investment returns, but strategic planning – such as leveraging capital losses – can assist lower the impact. 

By being informed about these nuances, retail investors can make smarter choices and optimise their financial strategy.