Budget 2024: How capital gains tax can be used to optimise capital allocation

As the Indian economy grows, there has been a rise in disposable income, which has led to an increase in savings and investment. Government initiatives aimed at financial inclusion, such as the Pradhan Mantri Jan Dhan Yojana, have brought more people into the formal financial system, providing them with access to banking services and investment products. At the same time, the Indian financial markets have seen the introduction of various investment products such as mutual funds, exchange-traded funds (ETFs), sovereign gold bonds, and more, providing investors with a range of options to diversify their portfolios.

For many years now, the appetites of Indian investors have extended beyond fixed income securities. Typically, the investors’ time horizon, risk tolerance and required ROI determine their asset allocation decisions.

However, differences in tax rates across various asset classes of securities / investments add complexity to capital allocation decisions which, other things being equal, factor only the intrinsic risks and rewards of these investments.

Complexities in The Current Tax Rate

Currently, tax rates and the holding period of investment for the long-term tag, vary for various instruments within the same asset category. Additionally, the advantage of adjusting for inflation is not uniform across different scenarios. Tax rates also differ for residents and non-residents.

The period of holding and long-term capital gains tax rate for various asset classes of securities are as under:

From the above table, one can identify certain differences in the period of holding of the various asset classes, such as:

*To qualify as a long-term capital asset, listed shares or debentures need to be held for 12 months, whereas unlisted shares and debentures need to be held for 24 months and 36 months respectively.

*While listed equity and debt instruments have a period of holding of 12 months, listed units of pooled investment vehicles such as mutual funds, AIFs, REITs and InvITs must be held for 36 months (with the exception of equity oriented mutual funds)

Similarly, one can identify differences in the current tax rates, such as:

- Listed units of AIF (20%) are not on par with listed units of REIT / InvIT (10%) which is not in line with the government’s outlook for the promotion of fund regime in India

- Non-resident subject to higher tax (20%) on certain listed securities (debentures, preference shares, units of AIF, ADR / GDR), while the same unlisted securities have lower tax (10%)

In case of short-term capital gains as well, certain asset classes (listed equity shares, equity-oriented funds, REITs and InvITs) are subject to 15% tax rate while the remaining securities are subject to tax at applicable corporate income tax rates or slab rates. So also, the surcharge on long-term capital gains is capped at 15%, while for short-term capital gains it can extend up to 25%.

Read | Reducing the proportion of cesses in tax collections will allow the budget to produce a bigger bang for the buck 

The benefit of indexation is also not available uniformly across asset classes. Long-term capital gains from equity shares, equity-oriented funds, units of REIT / InvIT, bond or debentures (with certain exceptions) are not eligible to benefit from indexation. Also, non-resident transferring long-term capital assets, being unlisted securities or shares of closely held companies, do not have the benefit of indexation.

Globally, Tax Treatment Varies

The international approach to capital gains taxation is diverse – which can be broadly classified as (a) not taxable and (b) taxable at rates lower than headline tax rates.

For example, nations such as Singapore, Turkey, China, and Malaysia exempt capital gains from taxes on publicly traded stocks. On the other hand, countries such as the US, the UK, France, and South Africa offer reduced tax rates for capital gains derived from publicly listed stocks, mutual funds, debt securities, and property. Meanwhile, other countries, like the Philippines, opt to impose the standard tax rate on such gains.

This is primarily driven by the economic imperative to incentivise allocation of capital for growing economic activity, in the form of either equity capital or debt financing.

A Uniform Tax Rate Structure

A uniform tax rate structure offers significant advantages by promoting simplicity, fairness, and efficiency within the tax system. When the tax rate is the same across asset classes, investors can make decisions based on the economic potential of the investment rather than the tax implications, as capital budgeting decisions are necessarily evaluated based on post-tax returns. This can lead to a more efficient allocation of capital, as investments are made in areas that offer the best returns without tax rate distortions.

This uniformity aids in levelling the playing field, as all taxpayers are subject to the same rate structure, thereby enhancing the perception of fairness in the tax system. It also fosters an environment conducive to investment by providing clarity and predictability for investors, which can drive economic growth. Overall, a consistent tax rate structure benefits the economy by reducing complexity, encouraging compliance, and promoting economic activities that lead to a more robust and equitable financial ecosystem.

Recommendations

The current complexity in tax rates can be simplified by having a more rationalised structure in place:

The above suggested rates/ holding period should apply both for residents and non-residents.

Ajit Krishnan is Tax Partner, EY India.

Views are personal, and do not represent the stand of this publication.