Stock market investments may be subject to tax risk

The revised code, if implemented in the present form, will complicate financial planning for investors.

The Securities and Exchange Board of India (Sebi) has mandated that mutual fund houses should always put this advertisement — “Mutual funds are subject to market risk. Please read the offer document carefully before investing.” 

Soon, another addition may be needed: “Mutual funds may be subject to tax risk."

The revised direct taxes code (DTC) proposal, while retaining the exempt-exempt-exempt regime for approved retirement corpuses, has thrown a googly at stock market investors. 

Financial planners are already saying that things have become more complicated in the revised draft code. The main grouse: Taxation of capital gains, both in the short term and long term.
 

THE 'ELUSIVE' NUMBER

• The revised DTC has proposed that long-term capital gains from stocks and mutual funds will be added to the income after 'allowing a deduction at a specific percentage of capital gains without any indexation'. The question: What will be this percentage?
• While the DTC papers have given generous illustrations of 50, 60 and 70 per cent, most feel that it is unlikely that such a high deduction will be allowed. 
• Also, since there is no prescribed benchmark as of now, there is a lack of clarity. And if the number is a variable one, which is quite likely, it would be quite difficult to predict. Consequently, financial planning over the long term will be hampered. "If one wishes to create a corpus through equities to purchase a house, say five years later, it would be very difficult to predict the 'percentage' that will applicable on that very year," said financial planner Gaurav Mashruwala.

“The revised version is more confusing, especially with regard to taxation of capital gains,” said Gaurav Mashruwala, a financial planner. In the short term, the entire capital gains would be added to your income and taxed.

At present, one pays 15 per cent tax on capital gains. So, if someone is in the 30 per cent tax bracket, his tax liability would increase from 15 to 30 per cent – a hike of 100 per cent. 

Also, the definition of short term has been changed. Now, if you acquire a financial product in June 2010, selling it before March 2012 will be construed as short-term capital gains.

“Any investment held for less than one year from the end of the financial year in which it is acquired will be computed without any specified deduction or indexation,” says the draft. Long-term capital gains, therefore, will be applicable if the financial asset is sold after 2012.

MORE TAX BURDEN

Short-term capital gains in equities (less than one year)
Existing: 15 per cent 
DTC 1.0: As a part of wealth (threshold taxable limit Rs 50 crore)
DTC 2.0: As a part of ordinary income and taxed, as per slab

Long-term capital gains in equities (over one year)
Existing: Zero
DTC 1.0: As a part of wealth (threshold taxable limit Rs 50 crore)
DTC 2.0: Gains to be reduced by a certain 'percentage', added to ordinary income and taxed, as per slab

Long-term complexities
Experts felt long-term financial planning could become a more difficult task. For example, if you want to travel abroad in the next three years, a financial planner would advise you to start investing through a systematic investment plan (SIP) of mutual funds. As you come closer to the goal, the corpus should be shifted to a debt fund for safety.

The revised DTC, if implemented in its present form, will make the calculation quite difficult. The proposal advocates a ‘percentage’ benefit for capital gains. After this, the capital gains will be added to your ordinary income and taxed, accordingly. 

In other words, say your travel cost after three years will be Rs 3 lakh. Assuming an annual rate of return of 12 per cent, you will need to invest Rs 8,625 per month for 30 months to reach that goal.

After that, you can shift the money to a debt fund. After 30 months, you would have made capital gains of Rs 41,250. If the rate of deduction (percentage benefit) is at 50 per cent, Rs 20,625 will be added to your income and taxed, on your applicable slab. But what if the ‘percentage’ is 30 per cent? The tax will then be imposed on Rs 28,875. 

In the present regime, in the long term, the investor does not pay any taxes. The first version of DTC proposed that mutual funds and stocks be included as a part of the wealth tax and hiked the limit from the existing Rs 30 lakh to Rs 50 crore.

On crossing the limit of Rs 50 crore, the proposed rate of taxation was 0.25 per cent. Financial experts said that clubbing a financial asset with wealth was an anomaly that has been removed now. 

However, most feel the securities transaction tax (STT) was a more potent route for tax collection.

“The present regime of STT has worked quite well for the government. Any malpractices that have emerged can be dealt with separately,” said N C Hegde, partner, Deloitte. He feels that the proposed capital gains guidelines may encourage shifting of assets to members of the family with a lower tax incidence.