Is There Any Benefit of Tax Deduction in India on the Interest Paid on Loan Against Security (Demat Holding) if the Borrowed Money Is Used To Purchase Further Stocks/MF?
Investors often use loans to acquire shares, most often through initial public offerings (IPOs) or on the secondary market. Consequently, they hope to earn a greater rate of return on their investment in the shares than they pay on the loan, resulting in a positive return on investment. Many people fail to realize that, while calculating their net returns, they should also consider the tax treatment of the interest they pay on their loans, since this tax may convert a gain into a loss.
How does this Tax treatment work?
Dividend income from shares was tax-free until a few years ago. Consequently, tax authorities would routinely disallow any claim for deduction of interest on loans taken for the purchase of shares, as the loans were taken to earn exempt income, and interest could not be deducted in computing taxable income.
It would have been expected that the interest would be deductible now that dividends are taxable. The law currently restricts the deduction for interest to 20% of dividends earned during the year. The major part of the interest paid by you on the loan would not be deductible if you have not earned a dividend, or a negligible dividend during the year. The provision appears to apply to the entire dividend income and not to income from a particular security.
The interest would therefore be allowed to the extent of 20% of the total dividends earned if a loan is taken for the purchase of a security that does not generate income during the year, but dividends are earned on other securities.
What happens to the remaining interest that cannot be deducted from dividends? Is that deduction lost, or is there some other way to claim it?
A number of decisions, primarily by the tribunal but also by a high court, have held that such interest that is not allowed as a deduction from dividends may be credited towards the cost of acquisition of the shares when computing capital gains when the shares are sold. Due to this, the deductibility of interest is delayed until the sale of the shares. The interest on a loan in such a case needs to be identified with the particular shares acquired from the loan and claimed against capital gains only on those shares. However, the tax department disagrees.
In IPOs where shares are allotted through loan funding, what is the position of investors applying for shares through loan funding? The financier deposits the funds into a bank account in the name of the investor, for which the financier executes a power of attorney. Under the ASBA process for applying for an IPO, the loan amount is disbursed into this bank account and a lien is imposed on it. Certain financiers earn interest on such bank accounts, while others do not. It is common for financiers to charge an interest rate on the loan amount as well as take the interest earned on the bank account. Allotted shares are sold, the financier withdraws the loan plus interest, and the investor receives the balance.
The interest paid on the loan funding can be deducted against bank interest, which is taxable if the person claims that the IPO application is an investment activity. Without these borrowings, it would not have been possible to earn the bank interest.
Therefore, these expenditures are incurred in order to earn income. It is possible that interest on a loan equal to the allotment money of the shares for the period between the time of the allotment of the shares and the time of the receipt of the sales proceeds of the shares may not be deductible as it would be attributable to the holding of the shares. Investors may wish to claim that such interest is deductible when computing capital gains on a sale of shares.
The interest can, however, be deducted as business expenses if tax certainty is desired for the deductibility of the interest. In this case, it would be necessary to ensure that any taxes on the interest paid are deducted at source.
It is therefore important to weigh the pros and cons of claiming short-term capital gains and paying a full normal rate of tax on gains net of interest or claiming long-term capital gains and not getting a tax deduction for interest paid.