Understanding how equity income is taxed is essential for investors. Equity investments generate two streams of income: dividends and capital gains, each with separate tax rules. The method used to determine which equity units are considered sold first – the FIFO (First-In, First-Out) rule – plays a significant role in how gains are calculated.
Dividend Taxation
For resident shareholders, dividends are:
- Taxed at slab rates, under the head Income from Other Sources.
- Interest on borrowings used to purchase shares is deductible, capped at 20% of dividend income.
- Other expenses (brokerage, commission, service charges) cannot be claimed.
Example:
Dividend received: Rs 1,00,000
Interest paid on loan: Rs 35,000
Deduction allowed: Rs 20,000 (20% cap)
Taxable dividend income: Rs 80,000
Capital Gains Taxation
Tax treatment depends on the holding period:
Long-Term Capital Gains (LTCG)
- Shares/equity mutual funds held >12 months.
- LTCG above Rs 1.25 lakh is taxed at 12.5%, subject to STT paid both on purchase and sale.
Illustration:
Cost: Rs 15 lakh
Sale: Rs 20 lakh
Gain: Rs 5 lakh
Taxable LTCG: Rs 3.75 lakh (after Rs 1.25 lakh exemption)
Tax: Rs 46,875
Short-Term Capital Gains (STCG)
- Shares held ≤12 months.
- Tax rate: 20%, assuming STT is paid.
Illustration:
Cost: Rs 15 lakh
Sale: Rs 17 lakh
Gain: Rs 2 lakh
Tax: Rs 40,000
How FIFO Determines Your Capital Gains
Investors usually buy shares in multiple lots over time. Under Indian tax rules, shares credited first to a demat account are deemed to be sold first.
Harsh Bhuta, Managing Partner, Bhuta Shah & Co LLP, notes:
“FIFO ensures uniformity in computing holding periods and prevents selective liquidation of advantageous lots.”
Example of FIFO in practice
Investor buys:
- 2,000 shares on 1 Feb 2025 @ Rs 50
- 2,000 shares on 1 Aug 2025 @ Rs 80
Sells 2,000 shares on 1 Dec 2025 @ Rs 105.
Under FIFO, the February lot is considered sold:
Cost: Rs 50
Gain per share: Rs 55
Total gain: Rs 1,10,000
STCG tax (20%): Rs 22,000
Using Multiple Demat Accounts to Manage Taxes
FIFO applies account-wise, not PAN-wise. Investors may legally maintain multiple demat accounts.
Vivek Rajaraman, Waterfield Advisors, explains:
“Each demat account has its own FIFO chain. Long-term and short-term strategies can be separated cleanly.”
Why this matters
If the second lot (bought at Rs 80) was held in a separate demat account, selling those shares would trigger:
Gain per share: Rs 25
Total gain: Rs 60,000
STCG tax: Rs 12,000
Compared to Rs 22,000 when everything sits in one account – a clear difference arising purely from FIFO mechanics.
Mihir Tanna, S K Patodia & Associates LLP, notes that this is a legitimate structuring choice, not a loophole. All trades are ultimately reported at the PAN level.
Key Takeaways for Clients
- Dividend income is taxed at slab rates with a strict 20% deduction limit.
- Long-term equity gains enjoy a lower tax rate and a Rs 1.25 lakh annual exemption.
- FIFO determines the cost and holding period; account structure impacts which lots get sold.
- Maintaining two demat accounts (long-term vs trading) helps avoid unintended tax leakage.
- The strategy is fully compliant and recognised by both depositories and tax authorities.