How gains through margin trading facility transactions are taxed in India

Understanding the MTF

In an MTF arrangement, the broker essentially provides a loan to purchase securities. The investor pays an initial margin, a percentage of the transaction value, while the broker finances the remainder. The broker holds the units as security and charges interest.

Taxability of MTF transaction gains

The nature of tax treatment depends on the type of income generated, categorized as follows:

1. In case of equity or equity-oriented mutual funds

Short-term capital gains (STCG): If the securities purchased on recognized stock exchange using MTF are sold within 12 months, the profit is treated as STCG. The tax rate applicable is 20% under Section 111A.

Long-term capital gains (LTCG): If the securities are held for more than 12 months, the profit qualifies as LTCG. LTCG exceeding ₹1,25,000 in a fiscal year is taxed at 12.5% without indexation benefits under Section 112A.

2. Business income

For frequent traders or those treating trading as a business, income from MTF transactions is classified as business income. Tax rates applicable depend on the investor’s income tax slab.

3. In case of debt-oriented funds

Under Section 50AA, gains from debt mutual funds are classified as short-term, regardless of the holding period, and are taxed according to the individual’s income tax slab rate.

Deduction for interest paid on margin funding

A key aspect of MTF transactions is the interest paid to the broker on the borrowed amount. The tax treatment of this interest depends on whether the income from MTF transactions is categorized as capital gains or business income.

1. Interest deduction for capital gains

The deductibility of interest on borrowed capital in the context of capital gains remains a contentious issue. While interest expenses on borrowed funds are capped at 20% of dividend income for dividends, no specific provision under the Income Tax Act allows the deduction of interest expenses from capital gains.

In some instances, courts have permitted the inclusion of interest expenses in the cost of acquisition, effectively reducing the taxable gains. However, the income tax department frequently challenges this stance, disallowing taxpayers from claiming such deductions. Given the increasing popularity of MTFs, it is anticipated that the income tax department will issue clarifications regarding the treatment of interest expenses associated with such transactions.

2. Interest deduction for business income

For traders treating MTF transactions as business activities, interest on margin funding is deductible as a business expense. Section 36(1)(iii) allows the deduction of interest on capital borrowed for the purpose of business.

Taxability of MTF transaction losses

Losses incurred from MTF transactions can be classified into capital losses or business losses based on the nature of the trading activity.

Short-term capital loss (STCL): STCL can be set off against short-term or long-term capital gains in the same fiscal year. Unutilized losses can be carried forward for eight assessment years and set off against future capital gains.

Long-term capital loss (LTCL): LTCL can only be set off against long-term capital gains. Similar to STCL, unutilized LTCL can be carried forward for eight assessment years and set off against future capital gains.

Business loss: Business losses from MTF transactions can be set off against income from any other source, except salary, in the same year. Unabsorbed business losses can be carried forward for eight years and set off only against business income.

Compliance and reporting requirements

Maintenance of records: Taxpayers should note that expenses, including interest, can only be claimed at the time of selling the capital asset. Accurate records of MTF transactions, including interest payments, brokerage charges, and stock details, must be maintained for accurate computation and claiming the applicable deductions.

Filing of tax returns: Gains and losses from MTF transactions must be reported under the appropriate income head in the income tax return (ITR) form. ITR-2 is used for reporting capital gains, while ITR-3 is required for business income.

While MTF can increase purchasing power, it carries the inherent risk of magnifying losses, as any depreciation in the stock value could lead to higher financial liabilities for the investor. The taxability of MTF hinges on the classification of the income generated and the treatment of associated expenses. While MTF can be a lucrative tool for investors seeking to maximize returns, it requires careful financial planning and compliance with tax regulations.

Neetu Brahma, consultant, Nangia & Co. Llp contributed to the article.

Neeraj Agarwala is a partner at Nangia & Co. Llp.