Who gains and who loses if FM changes tax norms in the coming Budget

Based on market intelligence, we outline three scenarios that may pan out in the Budget proposals this year, and assess their impact on your pocket

Every year during the fortnight preceding the Budget, a lot of expectation builds up among market participants about the sops the Finance Minister may offer this year. The government usually offers them to a sector, or a financial instrument, if it wants to enhance its attractiveness in the eyes of prospective investors. But it does so only if it believes that the benefits, say, in the form of additional investments attracted, will outweigh the losses in the form of revenue forgone.  

This year there is lot of speculation that long-term capital gains (LTCG) tax on equities may be abolished. Or, it may be removed but only after a longer holding period. Another expectation doing the rounds is that the holding period for capital gains to be treated as long-term may be made uniform across asset classes. Investors, however, need to temper their expectations. “The government has been lagging behind on its revenue collection targets, so there is a limit to how much revenue it can forgo by reducing tax rates or waiving them,” says Naveen Wadhwa, DGM, Taxmann.com. Let us examine some of the possible changes, and what they would mean for you. 

Scenario 1—LTCG on equities abolished: LTCG tax on equities reduces the returns that investors, including foreign portfolio investors (FPIs), earn from the money invested in Indian equities. If the government feels that the money garnered from this tax since its introduction is not meaningful enough, and that its removal may lead to enhanced FPI inflows into India, it may well do away with LTCG.

LTCG on equities was abolished in 2004 and re-imposed in the February 2018 Budget. If your gains in a financial year are above Rs 1 lakh on equities and equity-oriented mutual funds (on which securities transactions tax has been paid) held for more than a year, you get taxed at the rate of 10 per cent on the amount exceeding Rs 1 lakh. Suppose that your long-term gains from equities or equity mutual funds stand at Rs 2.5 lakh in a financial year, you currently pay a tax of 10 per cent on Rs 1.5 lakh, or Rs 15,000.

This tax came with a grandfathering clause. Any gains made until January 31, 2018 have been exempted. To explain with a basic example, suppose that an investor bought a share for Rs 100 in October 2017. On January 31, 2018, its price stood at Rs 120. He sells it in November 2018 at Rs 150. His long-term capital gain is Rs 50, but the government says it will apply tax only on Rs 30—the gains made after January 31, 2018.

Investors have been adopting various strategies to minimise the impact of LTCG on equities. As their goal approaches, they start withdrawing from equities around three years in advance. This is done so that the achievement of their goals is not affected by volatility in the equity markets. But it is also done to reduce the taxable gains by Rs 3 lakh (or Rs 1 lakh per annum). Similarly, when rebalancing their portfolios (selling equities if they have done well to bring the allocation back to normal levels), both wife and husband sell to rebalance at the family level. Doing so allows them to avoid taxation on Rs 2 lakh of LTCG in a financial year. If LTCG tax on equities goes away, they will not have to go to all this trouble.   

Scenario 2—Zero LTCG on equities after two years: The Finance Minister could make LTCG on equities and equity mutual funds zero, provided they are sold after a longer holding period of, say, two years.

Experts are of the view that most investors will regard this as a welcome move. “If you speak to any financial advisor, he will tell you that you should hold equity investments for at least 7-10 years. So, not having to pay any tax after two years will be welcome compared to the current regime where you have to pay 10 per cent on gains above Rs 1 lakh if you sell after one year,” says Deepesh Raghaw, founder, PersonalFinancePlan.in, a Sebi-registered investment advisor.

On the flip side, investors who are forced to sell their equity holdings in less than two years, because they need the money, will be forced to pay STCG tax. Those who wish to exit a fund because it has been underperforming may be forced to continue with it for a longer period if they wish to reduce their exit cost. Investors may also be faced with a hard choice if, during a bull run, they need to sell recently purchased equity assets to rebalance their portfolio.

Scenario 3—LTCG definition made uniform across asset classes: There is also an expectation among market participants that the holding period after which capital gains get classified as long-term could be streamlined across asset classes. Currently, the holding period varies from one asset class to another for it to be eligible for LTCG treatment. It is one year for equities, two years for real estate, and three years for fixed income and gold. “This variation makes the tax structure more complicated than it needs to be, and hence there is a need to streamline it,” says Ankur Maheshwari, chief executive officer, Equirus Wealth Management.

Earlier, debt instruments were also eligible for long-term capital gain tax treatment after a holding period of one year. This was raised to three years in 2014. In the case of real estate, the holding period has been kept at two years to give a fillip to the sector. Equity instruments have for long received favourable tax treatment because the government wants to attract greater retail participation into the equity markets.

If the holding period is made uniform for all asset classes, the impact will depend on whether it becomes one, two or three years. If it is made one year, then investors in real estate, debt and gold will stand to gain. If it is made two years, then debt and gold investors will stand to gain while equity investors will have to hold on for a longer period. And if it is made three years, then equity and real estate investors will have to invest with a longer horizon to avail of LTCG.