The capital gains regime is due for a change and here are the reasons why — the extant law is complex, unwieldy, and far from simple. The rates of tax vary for various classes of taxpayers — residents, non-residents, and foreign portfolio investors (FPI) — and differing rates are prescribed based on options to claim indexation benefits. The holding period for characterising short and long terms varies — 12 months for listed securities, 24 months for unlisted and real estate, and 36 months for other classes of assets. Focusing on the capital gains regime for securities (listed and unlisted) transactions, in the last 26 Budgets/Finance Acts since economic reforms of 1991, barring nine of them, all have seen amendments to the regime.
In December 2016, Prime Minister Narendra Modi hinted at change in the capital gains tax regime. “… those who profit from financial markets must make a fair contribution to nation-building through taxes ... To some extent, the low contribution of taxes may also be due to the structure of our tax laws … We should consider methods for increasing it in a fair, efficient and transparent way...”
The extant law has six rates of tax (nil, 10, 15, 20, 30, and 40) without factoring in rates that are derived due to indexation benefits coupled with the securities transaction tax (STT) levy for listed securities traded on the floor of the exchange.
Though the principle of horizontal equity should guide the policymakers in taxing passive income (such as capital gains on asset class, in general) and active income (such as salaries and business profits) at comparable rates, most nations, depending on economic considerations, either exempt them or tax them at concessional rates. India follows the latter except exempting gains from listed securities.
The regime needs to address simplicity, stability and predictability for the following reasons:
1. India’s thirst for capital will grow and a stable regime will attract an incremental dosage of capital to markets and business enterprises. Domestic, listed enterprises with proven business models and credible governance will continue to attract FPI.
2. A material part of corporate and domestic savings will find its way into investments in entrepreneurial businesses and capital markets. India has witnessed a visible rise in the post-demonetisation period in assets under management of domestic mutual funds and FPI investments. Despite fears of the US interest regime, the global outlook towards emerging economies is indicative of confidence in India’s capital markets.
3. Any form of tax (levied on transactions or on gains) is a pass-through cost for FPIs and domestic mutual funds as investors eventually bear the cost of such levy. For fund managers, the capital gains tax does become a matter of competitive choice, as one of the factors is ex-ante calculation of post-tax returns. Though other competitive factors such as the growth of the economy, the performance of the financial markets, rule of law, stable and predictable government policies do play an equally important role, tax certainty, particularly in the context of India, is an important factor.
4. FPIs and domestic mutual funds are expected to determine their net asset value on a daily basis. Hence, it is of paramount importance to ascertain its tax obligations (for the investors) with precision.
5. Changes in the 2017 Budget address tax-evasion concerns of the government on the circulation of unaccounted income through misuse of capital gains exemption for listed securities through the trading of penny stocks.
A case in point is the controversy on levying the minimum alternate tax (MAT) on FPIs as a result of actions of the tax administration in 2015. It’s only at the intervention of the senior-most political leadership that the Justice AP Shah Panel was constituted, and it led to an amendment in the 2016 Budget, calming the market nerves. In summary, for fund managers (and indirectly all forms of investors, institutional and non-institutional) a predictable tax regime is essential. Bold domestic tax and treaty policy steps in 2016 and 2017 have created a level playing field, a point made by PM Modi.
Therefore, any rejig in the regime will require a degree of consistency in holding period (across a class of assets or specified class of assets), stable and low tax rate with clarity on withdrawal/reduction of STT.
In conclusion, simplicity should guide the lawmakers to have:
- One rate or an exemption for all forms of taxpayers.
- Let the holding period stabilise at 24 months for all forms of assets.
- Levy tax at moderate rate and reduce the slabs to three — exempt, 5 and 10 per cent, with a corresponding reduction or withdrawal of the STT.
- Any upward revision of the tax rate, or the holding period, should be suitably grandfathered.
The author is founder, BMR legal and views are personal