Ensure the tax treatment of interest on loans taken out to buy shares

Many investors use loans to acquire shares, often through an initial public offering (IPO), and sometimes to acquire shares in the secondary market. They expect to earn a higher rate of return on their investment in the stocks than the interest rate they pay on the loan, thereby having a positive return. Often what they forget is that when calculating their net returns, they also need to consider the tax treatment of the interest they pay on their loans, as this tax has the potential to convert a gain into a gain. loss. What is this tax treatment?

Until a few years ago, dividend income you earned on stocks was exempt. The tax authorities would therefore systematically reject any request for deduction of interest on loans taken out for the acquisition of shares, on the grounds that the loan was taken out to earn exempt income and that the interest could not be claimed during the calculation. taxable income.

Now that the dividend has become taxable, one would have thought that the interest would be deductible. Unfortunately, the law now provides that the deduction of interest would be limited to 20% of the dividend received during the year. So if you didn’t receive any dividends, or a negligible dividend during the year, most of the interest you paid on the loan would not be deductible. Fortunately, the provision appears to be aimed at all dividend income, not income from a particular script. Therefore, if a loan is taken to purchase a particular script, which does not earn any income during the year, but dividends have been earned on other scripts, interest would be allowed up to 20% of the total. dividends earned.

What is the fate of the remaining interest, which is not allowed as a deduction from dividends? Is it lost or can we claim a deduction in some other way? There have been a number of decisions, mainly from the tribunal but also from a high court, which have ruled that such interest which has not been deducted from dividends may be claimed as part of the cost of acquiring the dividends. shares, while calculating capital gains on the sale of shares. The deductibility of interest is therefore carried over to the year in which the shares are sold. In addition, in such a case, the interest on the loan should be identified with the particular shares acquired through the loan and deducted from capital gains on the sale of those shares only. The tax office, however, does not accept this point of view.

What is the position of people applying for shares in IPOs through loan financing, where the shares are sold immediately upon allocation? In these cases, the money is deposited by the financier into a bank account in the name of the investor, for which a power of attorney is executed in favor of the financier. The loan amount is paid into this bank account, and a lien is marked on it as part of the ASBA IPO application process. In the case of some financiers, these bank accounts earn interest, while in the case of others, they do not. Most financiers charge interest on the loan amount and charge the interest earned on the bank account. When the shares are awarded, the shares are sold and the loan plus interest is withdrawn by the financier, and the balance is paid to the investor.

In the case of people who claim that such a request for shares through IPO is an investment activity, when interest is charged on the bank account, it is possible to take a position that the interest paid on the financing of the loan are deductible from this bank interest, which is taxable. Earning bank interest would not have been possible without such a loan, and it is therefore an expense incurred to earn that income. However, the interest on the loan up to the amount of the grant of the shares for the period from the date of the grant of the shares until the date on which the proceeds from the sale of the shares are received, may not be. deductible, as they would be attributable to the holding of shares. Here, an investor may wish to argue that such interest is deductible when calculating capital gains realized on the sale of shares.

However, if tax certainty is desired for interest deductibility, it is best to treat this IPO application activity as a business and claim the interest as a business expense. Of course, care should be taken to ensure that tax is withheld at source on interest paid, if applicable.

So you have to consider where you are best off: by claiming short-term capital gains and eventually not benefiting from a tax deduction for the interest paid, or by paying the full normal tax rate. on net interest gains.

Gautam Nayak is a partner, CNK and Associates LLP.

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