Taxation in case of Stock Lending and Borrowing
This sub‑topic covers the tax implications when securities are lent or borrowed under a stock lending and borrowing (SLB) arrangement. Understanding the tax treatment of fees, dividend handling and capital gains is crucial for investment advisers who guide clients on SLB strategies. The content links directly to the Income‑Tax Act provisions and SEBI guidelines, helping you answer exam questions accurately.
Learning Objectives
- 1Define stock lending and borrowing and describe the transaction flow.
- 2Identify how lending fees, dividend receipts and capital gains are taxed.
- 3Explain reporting requirements and TDS obligations for SLB transactions.
- 4Avoid common exam traps related to dividend taxation and cost‑basis calculations.
What is Stock Lending and Borrowing?
Stock lending and borrowing (SLB) is a short‑term arrangement where the owner of listed securities (the lender) temporarily transfers them to a borrower in exchange for a fee or interest. The borrower typically uses the securities for purposes such as short‑selling, arbitrage or fulfilling settlement obligations.
The transaction is governed by SEBI (Stock Lending and Borrowing) Regulations, 2014. The lender retains legal ownership, while the borrower obtains beneficial ownership for the agreed period. At the end of the term, the borrower must return identical securities to the lender.
For the NISM exam, remember that the fee earned by the lender is treated as ordinary income, whereas any capital gain or loss on the securities is determined based on the original cost basis of the lender. The borrower, on the other hand, treats any dividend received as a temporary receipt that must be returned to the lender.
- Key point – The transaction does not create a new acquisition; the original cost of the shares remains with the lender for CGT purposes.
- Key point – All fees and interest are taxable in the hands of the lender under "Income from Other Sources".
Students often think the borrower pays tax on dividends received. In reality, the dividend belongs to the original owner (the lender) and must be returned; the lender reports it as dividend income and pays tax accordingly.
Taxability of Lending Fees / Interest
The fee earned by the lender for providing securities is classified as "Income from Other Sources" under the Income‑Tax Act. It is fully taxable at the applicable slab rate of the individual or at the corporate tax rate for entities.
SEBI mandates that the borrower deducts Tax Deducted at Source (TDS) on the fee at the rate prescribed under Section 194‑J (currently 10% for residents, unless a lower treaty rate applies). The lender receives Form 26AS reflecting the TDS credit.
For exam preparation, remember the two‑step process: (1) gross fee earned, (2) apply the appropriate tax rate after accounting for TDS. Failure to consider TDS leads to over‑statement of tax liability, a common mistake in practice questions.
Where:
F= Total fees earned from stock lending (in rupees)TR= Applicable tax rate expressed as a decimal (e.g., 30% = 0.30)Worked Example
Given F = 5,000 ₹ and TR = 30% (0.30): Step 1: Tax Payable = 5,000 × 0.30 Step 2: Tax Payable = 1,500 ₹ Verification: 5,000 × 0.30 = 1,500.
Capital Gains on Returned Securities
When the borrower returns the securities, the lender’s cost basis remains unchanged. Any subsequent sale of those shares triggers capital gains tax based on the difference between the sale price and the original purchase price.
If the shares were held for more than 12 months before the original purchase, the gain qualifies as a long‑term capital gain (LTCG) and is taxed at 10% (without indexation) on gains exceeding ₹1 lac per annum. Otherwise, it is a short‑term capital gain (STCG) taxed at the individual’s slab rate.
Exam candidates should note that the SLB period itself does not reset the holding period. The holding period continues uninterrupted, which is a frequent source of errors in multiple‑choice questions.
Dividend Distribution on Borrowed Shares
During the SLB period, if the underlying company declares a dividend, the borrower receives the cash because they hold the beneficial ownership. However, the borrower is contractually obligated to pass the dividend back to the lender, usually on a gross‑plus‑tax basis.
The lender records the dividend as dividend income in their return and pays tax at the applicable dividend tax rate (currently 10% after the abolition of the dividend distribution tax). The borrower, having passed the amount back, does not retain any taxable dividend.
Remember for the exam: the dividend is taxed only once – in the hands of the original owner. Questions that ask "who pays tax on the dividend" expect the answer "the lender (original shareholder)".
Do not add tax on the dividend received by the borrower. The borrower merely acts as a conduit; the tax liability rests with the lender.
Reporting and Compliance Requirements
All fees earned from stock lending must be disclosed under "Income from Other Sources" in the Income Tax Return (ITR‑2 for individuals, ITR‑6 for companies). The TDS deducted by the borrower appears in Form 26AS and should be claimed as a credit.
Dividends received (and subsequently returned) are reported under "Income from Other Sources – Dividend Income". The lender must retain the SLB agreement and transaction statements for audit purposes, as the Income Tax Department may verify the authenticity of the fees and dividend flow.
SEBI also requires periodic reporting of SLB activity to the stock exchange, but for the NISM exam the focus is on tax reporting. Failure to disclose SLB income can attract penalties under Section 271(1)(c) for concealment of income.
Tax Treatment Comparison – Lender vs. Borrower
| Aspect | Lender | Borrower |
|---|---|---|
| Fees Earned | Taxable as Income from Other Sources; TDS @ 10% (Sec 194‑J) | No tax liability; deducts TDS on fee paid to lender |
| Dividend Received | Recorded as dividend income; taxed at 10% (post‑DDT) | Received temporarily, must be returned; no tax |
| Capital Gains on Sale | Based on original cost basis; LTCG or STCG as per holding period | No capital gain/loss as securities are not owned |
| Reporting | Disclose fees and dividends in ITR; claim TDS credit | Deduct TDS; no separate reporting of dividend |
Practical NISM‑Style Example
Scenario
Investor A owns 1,000 shares of XYZ Ltd. purchased at ₹150 each. He enters an SLB agreement for 30 days and receives a fee of ₹5,000. During the period, XYZ declares a dividend of ₹2 per share. Investor B receives ₹2,000 dividend and returns it to Investor A. At the end of the month, Investor A sells the shares at ₹170 each.
Solution
Step 1: Tax on fee – Using the formula, Tax Payable = 5,000 × 30% = ₹1,500 (assuming 30% slab). Step 2: Dividend – ₹2,000 is recorded as dividend income for Investor A and taxed at 10% = ₹200. Step 3: Capital gain – Sale proceeds = 1,000 × 170 = ₹170,000. Cost basis = 1,000 × 150 = ₹150,000. Gain = ₹20,000. Holding period > 12 months, so LTCG tax = 10% of ₹20,000 = ₹2,000. Total tax payable = 1,500 + 200 + 2,000 = ₹3,700.
Conclusion
The example illustrates that fees, dividend income and capital gains are each taxed separately. Remember to add TDS credit for the fee and apply the correct LTCG rate.
Tax Payable Components for a Sample SLB Transaction
⭐Exam Takeaways
- Stock lending fees are taxable as "Income from Other Sources" and attract TDS under Section 194‑J.
- Dividends received on borrowed shares must be returned to the lender; tax is paid only by the original owner.
- The lender’s cost basis for capital gains remains unchanged; the SLB period does not reset the holding period.
- Report fees and dividend income in the ITR and claim TDS credit shown in Form 26AS.
- Common exam trap – assuming the borrower pays tax on dividends; the correct answer is the lender.
Practice Questions
8 questions on Taxation in case of Stock Lending and Borrowing
In a stock lending and borrowing arrangement, the fee earned by the lender is classified as which of the following under the Income‑Tax Act?
Under Section 194‑J, what is the standard TDS rate applicable on the fee paid by the borrower to a resident lender?
Who is liable to pay tax on a dividend declared on shares that are temporarily held by the borrower under an SLB arrangement?
A lender earns a fee of ₹8,000 from stock lending. If the applicable tax rate is 25%, what is the tax payable on the fee (ignoring TDS)?
An investor held shares for 14 months before entering an SLB arrangement. When the shares are later sold, the gain will be taxed as:
Which statement about the holding period of securities involved in an SLB transaction is correct?
In which part of the Income Tax Return must a lender disclose fees earned from stock lending?
Using the example in the material: fee ₹5,000 (tax rate 30%), dividend ₹2,000 (tax 10%), LTCG ₹20,000 (tax 10%). What is the total tax payable by the lender?