COMMENT: Raids or capital gains tax hike? What is Modi‘s plan for market?

Over the last five years, tax authorities have been steadily plugging the loopholes which stock brokers exploited to help individuals evade taxes and launder black money

For instance, generating fake losses would help a client offset those against his genuine profits, and thus reduce income that can be taxed. Similarly, generating fake profits would help some clients show their undisclosed income as legitimate earnings from the stock market.

The fake profit/losses were generated by shifting transactions across client accounts after trading hours. The tax department dealt a blow to this racket by getting the stock exchanges to impose stringent penalties if brokers shifted their trades after market hours.

Another way to create fictitious profit/loss was by entering manipulated buy and sell orders in illiquid equity derivative contracts. This too has been curbed to a large extent by SEBI action against errant brokers.

Then there are companies listed on the stock exchanges for the sole purpose of helping people evade taxes or launder money. These companies issue shares which are subscribed to by tax dodgers/black money holders. The prices of the shares are then inflated by entities that act as fronts for such companies. The subscribers of the shares then sell the inflated shares to the fronts a year later, thus showing the profits as legitimate income from the stock market. The profit is then routed back to the companies through a series of what appears as business transactions.

In March this year, the SEBI banned 240 entities for capital gains tax fraud after an investigation spanning nearly 15 months.

Clearly, it is becoming quite tough to use the stock market to distort income or launder money. But loopholes remain nevertheless.

Brokers say there is a thriving cash economy in the stock market, which allows big traders and high networth individuals to escape the taxman’s glare.

The modus operandi is simple: many brokers transact for their big clients in cash instead of cheque, in clear violation of the SEBI rules.

If the client makes money, the broker gives him the profit in cash. If the client loses money, he pays it to the broker in cash. Such an arrangement helps the big traders because they don’t have to disclose the income at all. Given the nature of this arrangement, there is no paper trail to link the client to the broker.

The broker’s challenge is to keep balancing his books constantly, and hoping that all his bulge bracket clients do not make too much profit. If that happens, he will be liable to pay capital gains on those trades since for the Income Tax, he is the one doing all the trades.

But for the veteran market players, that is not a very big headache and can be fixed by bribing Income Tax officials.

In his maiden Budget as Finance Minister, Manmohan Singh in 1991 had tweaked the rules on short term capital gains tax to clampdown on tax evasion.

This is what he had said in his speech:

“The present provision for offsetting short-term capital losses against income leads to tax avoidance. I, therefore, propose that any loss on transfer of a capital asset will be set off only against gain from transfer of another capital asset. This is only logical. It should also stop the practice of buying short-term capital losses being resorted to by some unscrupulous tax payers.”

But Singh may not have bargained for the ingenuity of the tax evaders and their chartered accounts, and the complicity of tax officials.

In 2004, when Finance Minister P Chidambaram had scrapped long term capital tax gains and introduced securities transaction, the idea was to promote long term investments in equities by retail investors. Over the years, it has worked to the benefit of promoters who save big on taxes when selling stakes, by paying a pittance as securities transaction tax. 

Also, it has led to a thriving industry in tax evasion through shell companies.

So far, the government has repeatedly turned down repeated proposals by the stock market community to scrap the Securities Transaction Tax (STT) and instead increase capital gains tax. That is because STT is collected at source by the stock exchanges and is impossible to avoid, even if the collection may not be as huge as some of the other taxes. In the case of capital gains tax, it is very much possible to manipulate taxable income, besides persuading some of the tax officials to turn a blind eye.