TAX LOSS HARVESTING — A Strategic Tool

Harvesting losses can be an effective year-end, tax-cutting strategy, especially so with capital gain tax rates for taxpayers shooting up with every Budget

Note: This is a comprehensive white paper, for a simplified step-by-step guide to tax loss harvesting, check out our guide to tax-loss harvesting.

Aim:

The aim of harvesting losses is to offset gains from sale of investment securities with unrealized losses of investment portfolio and further using any remaining loss to offset other incomes. Losses beyond the set off rules may be carried over to succeeding year.

What is Tax loss harvesting?

Tax-loss harvesting is the practice of selling stocks, mutual funds, and other securities that have declined in value. By realizing or ‘harvesting’ a loss, investors are able to reduce taxes on both gains from other investments and from income.

In Brief -
Tax-loss harvesting is a mechanism to generate tax savings from your investment portfolio.

1. Certain investments from the portfolio of the investor that have unrealized losses are sold and a tax loss is booked before the end of a financial year.
2. These are then replaced with similar, highly correlated investments so that the portfolio remains unchanged. Or the same shares can be bought after a gap of 2 days (T+2) from the date of sale of shares. However, there is a slight risk of the stock moving up within those 2 days gap.
3. The tax loss can be used to offset other taxable incomes of the year, thus resulting in tax savings.
4. The costs involved are largely the transaction related costs which are very meager in comparison to the taxes saved.

This technique may be very useful when an investor is already thinking of getting of an investment due to high costs or in order to diversify a portfolio.

Key tax information

Income of a person for a financial year shall be taxable in the relevant assessment year.

For example, income earned in financial year (F.Y.) 2016–17 shall be taxed in assessment year (A.Y.) 2017–18. Income must be classified into the five heads of income namely Income from Salary, Income from House Property, Income from Business or Profession, Capital Gains and Income from other sources for calculating tax liability as treatment for each head is different.

In order to understand the most economical way to do tax loss harvesting, one needs to be aware of the basics of Capital gains and business income in respect of securities.

How to determine the nature of income for purposes of taxation?

Deciding whether income from securities partakes the character of Capital Gains or Non-speculative business income or Speculative business income, more or less depends on these four things:

1. Active trading in equity — the income arising shall be taxed as Non- speculative business income.
2. F&O trading- the income shall be taxed as Non-speculative business income.
3. Intraday trading– the resultant income shall be termed as Speculative income.
4. If securities are held as investments, sale of securities once in a while would yield ‘Capital Gains’. Capital gains are further classified into Long-Term Capital Gains (LTCG) and Short-Term Capital Gains (STCG) depending on period of holding of securities.

Caution

1. The type of security, nature, volume and frequency of transactions etc., forms the basis for determining if the person is an active trader or an avid investor. There are various circulars of CBDT in this regard.
2. Not all losses can be set off with all gains, so tax provisions relating to set off of losses play a vital role in formulating tax planning strategies.
3. The extent to which a type of loss can be carried forward is also defined as per the Income Tax Act, 1961. One must keep a track of the same to enjoy complete benefit.
4. Many strategies such as bonus stripping, dividend stripping, averaging of profits are used along with tax loss harvesting to optimize taxes. Most of these are not ethical and are under tax net in the existing tax regime. Hence, alarmed and conscious action would pave a long way to save taxes and reduce litigations upfront.
5. One needs to consider individual trades and book losses on declined investments so that the overall profit is optimized.
6. It is better to use short- term capital losses to set off STCG since STCGs are taxed at a higher rate than LTCG.

Taxation of Business Income and Capital Gains

Business Income-
Any business income will always be taxable as per normal slab rates applicable to the person. For every business, a separate profit and loss account considering all expenses and incomes relating to that business and a balance sheet showing position of assets and liabilities as on year end will have to be prepared.

Capital Gains-

Gist of relevant tax laws and rules

1. Long-term capital loss can be set off only against Long-term capital gain. However Short-term capital loss can be set off against Long-term capital gain or Short-term capital gain.
2. Carry forward of capital Loss is allowed for eight years succeeding the year of occurrence.
3. Loss from speculative business can be set off only against income from speculative business. Such losses can be carried forward for a maximum of four assessment years immediately succeeding the assessment year in which loss was first computed.
4. Loss from non-speculative business can be set off against any source or head of income except income from salaries. Any non-speculative business loss that could not be set off in a particular year can be carried forward to the next assessment year and set off against any business income. The loss can be carried forward for eight assessment years immediately succeeding the assessment year in which the loss occurred.
5. It should be noted that for the purpose of taxation, intra-day transactions constitute a distinct and separate business irrespective of the volume and frequency of transactions. Such business is termed as a ‘Speculative business’.
6. Actively trading in securities as a trader and trading in derivatives would constitute a non-speculative business/normal business.
7. If due to booking of losses the profit percentage of the business falls below 6% of turnover, or if the turnover as calculated as per the guidance note on section 44AB of the Income Tax, 1961 exceeds Rs. 1 crore a tax audit will be required under the Tax Laws. This limit is to be checked business wise.
8. A salaried individual having losses from derivatives trading cannot get benefit of tax loss harvesting unless he has any other source of income like LTCG from sale of equities over Rs.1,00,000 or STCG or income from house property, income from any other business etc., as loss from derivatives cannot be offset against income from salary.
9. For a business, all expenses such as electricity, rent, depreciation, brokerage, STT etc. incurred to run the business shall be allowed as a deduction.

Illustrations

1: Investor, say Mr. Sharukh

Mr. Shahrukh is a long-term investor who buys and holds equity shares for long term capital appreciation. During June last year, he had purchased shares of company ABC worth Rs. 1 lakh. Few days back, it’s value increased to Rs. 2 lakhs and after performing an in-depth analysis of the share.

Shahrukh felt that the share price is its peak and won’t see much movement in the next 1 year so he decides to exit with a profit of Rs. 1 lakh.
Now, this is a short-term capital gain since the holding period is less than 1 year and since it’s listed share, the gains will be taxed at 15%

Tax outflow of Shahrukh — 15% * 1,00,000 = Rs. 15,000

Shahrukh had also bought shares worth RS. 1 lakh of company ‘XYZ’ in July last year. The value of the shares has reduced to Rs. 50,000 now. Shahrukh plans on holding this share for next 2 years as he feels the share has a lot of potential. Under a normal scenario, Shahrukh would continue to hold the shares and pay his tax liability of Rs. 15,000.

However, Shahrukh meets a smart tax planner who tells him about tax loss harvesting.

Now, Shahrukh decides to sell the shares of company XYZ as well and books a loss of Rs. 50,000.

Now his net tax liability would be Rs. 7500 [(1,00,000–50,000) *15%]. He buys the shares of XYZ again after a gap of 2 days, i.e. after settling the shares sold (T+2).

Shahrukh understood that the 2-day gap is the only risk element where the stock price can rise and result in a negative effect, but he was willing to take that chance.

Further, the tax planner also informed Shahrukh about the possibility of buying a share with a correlation of 1 to mitigate the risk of the 2-day gap if he wishes to.

2: Trader of Securities, say Mr. Sahu

The same example would apply for a trader as well. The only difference would be that instead of the tax being 15% as capital gains, the gains would be taxed as business income according to the slab rate.

Heads up

Until now, the LTCL which arose on sale of Listed Equity Shares was a dead loss since the corresponding LTCG on sale of listed equity shares used to be exempt from tax. In light of the new tax regime, it might so happen that LTCL from sale of equities up to Rs. 1,00,000 shall be a dead loss and it will not have any tax treatment. The loss in excess of Rs. 1,00,000 shall be eligible for set off and carry forward. Similarly, only the gains over Rs. 1,00,000 might be available for offsetting losses. As of now there is no notification or clarification of CBDT in this regard.

Economic viability

Tax- loss harvesting only defers taxes and the real savings come due time value of money. The taxes saved in a year can be invested to earn returns. The longer the term of investment, higher will be the earnings due to compounding effect.

Consider the example given above. Though tax savings of Rs. 7,500 can be reinvested to earn interest, effectively we cannot say that Sharukh’s wealth has increased by Rs. 7,500. This is because on selling shares of XYZ co. for Rs. 50,000 and investing these proceeds to buy same shares again; the cost of investment has gone down by Rs. 50,000. Suppose in the future these shares are liquidated at Rs. 1,00,000, gains of Rs. 50,000 will arise. Assuming that the STCG tax rate remains 15%, tax liability will be Rs. 7,500. In such a scenario, the tax saved earlier is wiped off and the earnings of Sharukh due to tax loss harvesting would be interest/income from investing Rs. 7,500 for the period of tax deferral.

In this example, the underlying assumption is that income-tax rates will be the same at the time of harvesting losses and at the time of recognition of subsequent gains. But the actuality is that every year various tax amendments are introduced in the Finance Bill and thus, it might so happen that the tax rate is increased or lowered.

In case the future tax rates are lowered or the tax payer falls in a lower slab in the future, in addition to the earnings from investment of taxes deferred he will also earn due to the lowered future tax rate. For instance, in the year of resale of XYZ co. shares if the tax rate gets reduced from 15% to 10%, the tax on gains would be Rs. 5,000 (10% of Rs. 50,000). The tax deferred due to tax loss harvesting was Rs. 7,500. The difference of Rs. 2,500 is earned by Mr. Sharukh due to lowered future tax rate.

On the other hand, where the tax rates are increased the practice of loss harvesting might have a negative effect. For instance, in the year of resale of XYZ co. shares if the tax rate increases from 15% to 25%, the tax on gains would be Rs. 12,500 (25% of Rs. 50,000). The tax deferred due to tax loss harvesting was Rs. 7,500. The difference of Rs. 5,000 is lost by Mr. Sharukh due to increased future tax rate.

However, if the interest earned from investment of Rs. 7,500 is more than or equal to Rs. 5,000 there will be no loss. An investor who is not willing to take this risk can harvest losses only to set off the income of that year.

Reminder

Please note that to book the loss for this financial year, you have to exit the stocks before March 31, 2018. The last trading day of this year will be 28th March, 2018.

Comments

This strategy should not be looked at in isolation. It should be evaluated after considering different aspects such as risk and diversification of portfolio, tax effects and investment opportunities for maximisation of wealth and avoiding undesirable contingencies.

Many features are to be examined in deciding the viability of this strategy, some of them are:

1. Whether the investor wishes to replace the investment being sold;
2. The possible implications of tax provisions, which can prevent an investor from claiming any benefit of tax loss harvesting;
3. The amount and nature of the gain incurred on the investment;
4. The applicable tax rates, and the possible benefits of offsetting incomes;
5. If the investment sold is replaced, the effect of resetting the investor’s cost basis and holding period;
6. The effect of harvesting losses on the investor’s income;
7. Whether the loss harvested will result in a loss carry forward beyond the current tax year, or whether the investor already has an existing loss carry forward from previous years;
8. Possibility of increase in future tax rates and effect of this on the practice

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