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Taxing derivatives trading

Business Standard  |  New Delhi 

By all accounts, the action taken by the government and the Securities and Exchange Board of India (Sebi) for stopping the practice of issuing participatory notes with derivatives underlying has been effective, and derivative P-notes are no longer issued. However, if such offshore trading is to be brought to the country "" which was one of the objectives "" then the government needs to address the crucial point of tax policy. For it so happens that while foreign institutional investors (FIIs) can avoid paying the capital gains tax on their share investments in India, no such exemption is available when it comes to profits made from trading in derivatives "" where the full income tax rate applies, even if the FII has come through the tax-free Mauritius route. This is a powerful incentive for such trading to remain offshore, and certainly exceeds the costs incurred in paying the securities transactions tax or any other levies.
This raises the larger question of whether there should be preferential tax treatment for profits made on the capital market, and indeed no capital gains tax at all when securities are held for more than a year. There is no shortage of commentators who argue that this is manifestly unfair when other forms of income are taxed at the peak rate of nearly 34 per cent; indeed, many economists with policy-making experience also have strongly critical views when it comes to the favourable treatment given to dividend income "" and it is hard to argue that they have no case at all, although it remains this newspaper's view that taxing dividends is to tax the same income twice over.
The issue at hand, though, is whether the government should treat trading in derivatives in the same way that it treats trading in listed shares, when it comes to tax policy. If the long-term objective is to develop Mumbai as an international financial centre, which involves bringing more and more financial activity to the city and therefore onshore, then there may be no escape from reviewing the tax treatment of derivatives trading. As for those who would argue that the over-riding principle of fairness should not be forgotten when undertaking such a review, it would be as well to bear in mind how important tax treatment has been for developing even as established an international financial centre as London. One reason why the British capital has been a more attractive proposition than alternative financial centres in Europe (like Frankfurt) is that the UK government continues to give favoured tax treatment to foreigners who come to work in the country "" they are not taxed in Britain on any income that they do not bring into the country "" whereas tax policy in other countries provides for no such glaring loophole. Attention must therefore focus on the specific policy goal. If the objective is to develop a financial centre (which brings with it many associated benefits), and if tax policy comes in the way of that, then you have to either give up the objective or amend tax policy. In the immediate context, it is important to realise that the main stumbling block is in fact tax policy.

First Published: Tue, November 06 2007. 00:00 IST