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Budget 2013: Taking out STT might reintroduce Long Term Capital Gains Tax

The call to remove Securities Transaction Tax (STT) is often from traders and brokers, looking to decrease their transaction cost. However such an action has a huge problem in that it will reintroduce capital gains tax on long term transactions in shares.

In 2004, STT was introduced and at the same time, long term capital gains tax was removed by stating that if you sell after a year of purchase, and pay the STT on a stock market transaction, you will not need to pay long term capital gains tax. Off market transactions, such as share buybacks by a company, will not pay the STT, so any gains made there are taxable under the long term capital gains tax regime. The tax for listed shares is currently 10% of the profit or 20% of “indexed” gains (that is, gains indexed to inflation) whichever is lower. 

Also see: How to Calculate Long Term Capital Gains Tax.

Note that this applies to equity oriented mutual fund transactions too.

However, let’s take a smart look at STT. This year to January, collections were a mere 3,300 cr, nearly 10% lower than last year. It’s not a huge source of revenue for the government. For traders, who pay between 1.7 and 2.5 basis points for intraday/futures transactions and 25 basis points for delivery transactions, the cost can be defeating. (1 basis point is 0.01%) But it’s great for investors who can pay that tiny amount and then, not pay long term capital gains tax.

The lack of long term capital gains tax hasn’t really attracted investors. It must have for the first three years – the markets rallied from 2004 to 2007. However, after that, there’s been very little action, and delivery volumes on stock exchanges have actually dwindled. This is not because of STT, and the incentive of zero long term capital gains taxes have not worked.

But removing this incentive might crush the market. FIIs get a tax free ride anyhow, through the Mauritius treaties. If a long term tax was introduced on local investors, it would be akin to subsidizing foreign investors at the cost of local ones. The immediate impact would be a massive sell off, as long term holders liquidate their holdings to not have to pay long term gains taxes on current holdings (and perhaps, buy the shares back to indicate a new high price).

The only way long term capital gains taxes can be reintroduced is to offer free gains upto, say, March 31, 2013 and then have capital gains taxes beyond that. This is not a very simple addition to the tax law, which means you have a different treatment for purchases before the cut-off date and for those after. I don’t believe the FM is likely to have this happen.

What can be done however is to remove the obscene cost of STT on options that are exercised. The difference between selling before the expiry day and holding an option to expiry can be huge, and upto Rs. 7 per option today. STT is 0.017% of the option price if sold before expiry (for both in the money and out-of-the-money options). But if you let it expire in the money, you pay 0.125% – the “delivery” rate – of not just the option price, but of the settlement price.

See: Beware of STT when trading options (Plus Video)

If the Nifty expires at 5950, the 5900 call option will receive a sale value of Rs. 50, but pay 0.125% of 5950 (the settlement price) which is Rs. 7.43. This is equivalent to a tax of 15% for you! The FM can fix this anomaly by providing for STT only on the premium received.

Overall, I wouldn’t wish away STT because then we have to see the impact on long term capital gains taxes and how the new language, if any, will benefit or hinder shareholders. But it might be a tricky issue we have to deal with in Budget 2013.

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