Capital gains tax: A capital conundrum

In the pantheon of taxes, perhaps no other tax evokes as powerful a passion and emotion as the capital gains tax does. This is in no small measure due to the invariable link with global capital markets. At one end of the spectrum is the “purist” view, which holds that there should be no distinction between ordinary income and capital gains — and accordingly, capital gains should also be taxed at normal slab rates applicable to a taxpayer. This would ensure that the progressivity of taxation is maintained and that the upper crust of taxpayers is taxed at the maximum marginal tax rate. Interestingly, this topic has been a topic of debate in the US ever since preferential tax treatment for capital gains was introduced there a century ago. Defenders of preferential tax treatment argue that capital gains tax is a form of “double taxation” as corporate profits are taxed as ordinary income. The corporation pays a tax on its income and then the company’s owner, or equity holder, is taxed again when he or she sells stake.
 

Another argument put forward for preferential rates is the inherent inflation embedded in the value of capital assets, which effectively results in a tax on inflation. Finally, a preferential rate on capital gains serves as motivation for savings and investments in the “productive” sector of the economy (shares and property), reducing the fiscal burden on the government to invest in capital goods. In the US, therefore, not only do the preferential tax rates on capital gains prevail but the minimum holding period to avail long-term tax benefits is also an attractive 12 months.

To add to the complexity of the debate, many countries exempt non-resident investors from capital gains tax on “productive” assets like capital market securities. This policy feature seems to have played a pivotal role in the development of giant capital market hubs in places such as the US, the UK, Hong Kong and Singapore.

In India, over the years, there have been several changes in taxation of capital gains. As a result, there is a lack of consistency in holding periods, tax rates, and indexation benefits. The prescribed holding period to qualify as a long-term asset ranges from 12 months to 36 months across asset classes. Similarly, capital gains tax rates range from normal slab rates (short term) to 15 per cent (short term on listed securities) and 10-20 per cent (long term). Non-residents are taxed 10 per cent on unlisted securities (including REITs and InvITs) whereas residents are taxed 20 per cent on long-term capital gains (LTCG) on these securities. Indexation benefit on purchase cost is also inconsistent. For example, it is not available for the following:

• LTCG arising from transfer of an equity share, a unit of an equity-oriented fund, or a unit of a business trust as referred to in Section 112A.
• Bonds or debentures (except government-issued capital-indexed bonds and sovereign gold bonds).
• For non-residents, capital gains from transfer of unlisted shares (which is taxable at concessional rate of 10 per cent).

India, therefore, has a great opportunity to simplify the LTCG treatment. The holding period to qualify as LTCG for all types of financial assets (listed/unlisted shares; units of all types of mutual funds, REITs and InvITs; all types of debt instruments, etc) should be aligned to a uniform 12 months to ensure that investment decisions are not distracted by artificial distinctions in holding period of assets. At the same time, the holding period of immovable properties should be aligned to three years as is the case with other non-financial assets. Similarly, there is a strong case to align the rate for LTCG at 10 per cent and short-term capital gains tax at 15 per cent for all types of financial assets. In the same vein, there may be no need for indexation benefits on LTCG on financial assets if the rates and holding period are aligned as mentioned above.
 

India is at the cusp of formalisation of its economy with increasing flow of savings into financial instruments. Equity investments by foreign portfolio investors, foreign direct investors and domestic investors have steadily increased. These can provide the much needed lifeblood for India’s aspiration to become a developed, $25-trillion economy by 2047. Our capital gains tax regime should serve as an effective lubricant for this ambitious vision.

The writer is partner, tax and regulatory services, EY India