Budget 2023: Simplify taxes on investments without hurting markets

At present, the government has not imposed any fresh taxes on the middle class, said Finance Minister Nirmala Sitharaman

India’s capital markets have outperformed those in peer emerging economies, generating returns for investors when wealth globally has been destroyed amid geopolitical events and the dregs of the pandemic. This gives a perfect opportunity for a government keen to streamline taxes on investments.

The debate is whether the government should leave a considerable amount of wealth with investors to boost equity market sentiment or get its pound of flesh from the recent gains.

“Any decision on capital gains taxation on the sale of listed equity shares and units of an equity-oriented mutual fund (short or long term) is likely to have a direct impact on the Indian equity markets,” said Parizad Sirwalla, partner and national head – tax, global mobility services, at KPMG India.

The benchmark indices have returned 3.8 percent so far in FY23. This may seem small, but it comes after a sharp drop post pandemic. Equity-oriented funds attracted a deluge of inflows through systematic investment plans. Then there are the outsized gains made in the past two years as the pandemic increased savings, a part of which flowed into equities.

Worries that the government could increase long-term capital gains (LTCG) tax rates have emerged even as investors hope the Centre will simplify and rationalise the rules without bruising market sentiment. However, tax experts pointed out that the plethora of taxes on securities transactions are too complex to address at one go.

Pop goes the logic

To say Indian tax laws are complex would be an understatement. Chartered accounts and tax consultants rue the fact that they still have to refer to multiple sets of rules and rates for a simple advisory on a single asset class.

For instance, the holding period of an asset for LTCG tax consideration varies for equities, debt and physical assets such as real estate and jewelry. Within equities, LTCG tax is 10 percent up to Rs 1 lakh and 20 percent above Rs 1 lakh with indexation benefit.

Holdings of less than a year attract short-term capital gains tax of 15 percent.

“The rationale for different tax rates is essentially what the government believes it should do to either incentivise or disincentive investments in a particular asset class,” said Gautam Nayak, an independent tax expert and chartered accountant.

That means some tax rules have ended up introducing anomalies in the market.

More than complexity, tax laws tend to offer unintended arbitrage opportunities. In the case of share buybacks via the stock exchange, investors who participate in the transaction pay capital gains tax while the company pays a buyback tax even. In instances where an investor in the company may be buying back shares, this results in an unnecessary double taxation. Further, investors who do not participate in the transaction end up on the losing side because the taxes that the company pays is carved out of profits, which would otherwise be available as dividends. The Securities and Exchange Board of India is said to be working to address some of these dichotomies.

There is also the case of different asset classes treated similarly.

Long-term debate

Tax experts said tinkering with LTCG tax rates could dampen investment sentiment.

“Increasing the tax rates on LTCG will act as a deterrent to economic sentiment. Not increasing LTCG tax rates from the present level would help India to retain its competitive advantage,” said Sudhakar Sethuraman, a partner at Deloitte India. “In Singapore, there is no tax on capital gains. The UK provides an exemption up to GBP 12,300 for capital gains, beyond which the gains are taxed at 10 percent. LTCG gains are taxed at 15 percent in the US and in Thailand, while the rate goes up to 20 percent in Australia.”

Tax consultants acknowledged the need to simplify the current regime. Towards this, the recommendations of a taskforce set up in 2019 may serve as a key reference point.

Taskforce blueprint

The taskforce recommended changes, albeit not dramatically different from the current regime. It recommended LTCG tax of 10 percent on all equity investments held for more than a year without indexation benefits. It recommended three classes of assets for taxation: equity, non-equity financial assets and all others including real estate.

It also suggested a holding period of two years for all financial investments, which would mean debt fund holdings may get their period reduced from the current three years.

Tax experts said the current rules are cumbersome when it comes to LTCG. “There is the usual expectation that the entire capital gains tax regime may be revamped to make it more simplified and easier to understand, perhaps by having fewer number of holding periods (for classification as long term vs short term) as well as fewer tax rates, depending on asset type,” said Sirwalla of KPMG.

One demand has been to bring listed and unlisted equity holdings at par for taxation. Yet another has been to reduce the holding period requirement for debt mutual fund units to two years. The taskforce recommended this, too.

A worry is that such rationalisation may involve an increase in tax rates for equity investments as the government seeks more fiscal space to spend. The key question, though, is whether tweaks in taxes on investments are worth the effort when they do not move the needle on revenue for the government.

Minor revenue boost

The government does not specify the share of capital gains tax in its direct tax collections. But an indication of this was given by former revenue secretary Tarun Bajaj last year. Bajaj had said that at an expected collection of Rs 60,000-80,000 crore for FY22, capital gains tax would contribute about 6 percent of total direct tax collections. The upshot is that the share of capital gains tax in overall tax revenue is in the low single digits.

Even the much fretted over securities transaction tax (STT) forms a mere 2 percent of total direct tax collections. Introduced in 2014, STT is levied on stocks, equity derivatives and equity mutual funds at the time of sale and purchase. Sethuraman of Deloitte said STT exemptions could be considered in lieu of capital gains tax.

In such a scenario, tinkering with taxes on securities should be done carefully and in a way that does not hurt the market. The fact remains that the contribution of capital gains tax remains low and is unlikely to be worth the outcome of a worried capital market when global sentiment threatens to cast a shadow on the emerging markets.