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Economy

Make Long Term Capital Gains Tax Free Only After Three Years of Holding

Equity capital gains are free if you sell shares after a year. You don’t pay long term capital gains taxes for shares sold on a stock exchange.

But if you look at other “assets”, equity is getting a great deal:

  • For gold, you have to hold for three years before you get “long term” gains, which are taxed at 20%.
  • For real estate the house has to be held for three years, and again 20% gains taxes apply (though taxes can be offset if you buy a new house)
  • For debt mutual funds you have now hold for three years before you can apply “indexation” benefits and claim long term capital gains (which are 20% of indexed gains, or 10% of unindexed gains, whichever is lower)
  • For unlisted companies, you pay 20% capital gains taxes if you sell shares after a year. (This is still one year, but the taxes are large)

Listed stocks are the only real asset class where, after just one year, you pay no taxes whatsoever.

This is being abused to launder black money

Consider this scheme:

  • A person called “Bhushan” owning shares in “black” buys 5 crore shares today, of a small listed company, in a preferential deal at Rs. 1 per share
  • Some operators do circular trading and move the share price up to Rs. 500 per share.
  • This process is done over one year.
  • “Bhushan” then transfers Rs. 2500 crores in black money out of India through the hawala mechanism to a foreign country.
  • This money in the foreign country is then put in an “FPI” (a foreign portfolio investors) which has big names in it like Merrill Lynch and so on. Because to them, the foreign entity is legit.
  • That FPI account then buys this Rs. 500 share from “Bhushan” at that massive valuation, from the market, for Rs. 2500 crores.
  • “Bhushan” now pays zero taxes, because the capital gains on his investment is Long Term (more than 1 year).
  • “Bhushan” has just converted Rs. 2500 cr. from black to white money!

This is not an insane case. Recently, SEBI banned 260 entities for doing something like this, including the promoters of the troubled Bhushan Steel.

 

I will submit that you could do this over one year, but if it were any longer, say three years, then such manipulation would be very risky (because SEBI, which acts after one year anyway, will probably be able to detect and trace such manipulations).

The Tax Benefit Has Achieved Its Goal

One reason to provide the tax-free gains for equity shares was because the stock market was under-served and to promote investment. This has achieved its purpose. More investments are coming into the market than ever before. And the market is near or at all time highs.

The need now might be to promote longer term investments. As India matures, long term will mean three years, not one.

And the Government’s Running Out Of Money

And then, we know that the government has no money. It’s running a huge budget deficit due to lower tax collections and stable expenditure (which it’s trying to cut because it is not able to earn enough by way of taxes).

See: Fiscal Deficit Higher, at 99% of it’s Full Year Target as of November 2014

Here It Comes: Remove the One Year Tax-Free Benefit for Equity Shares

We know that:

  • In no other asset class do you get tax free gains after one year – at best, it’s after three years.
  • The one year tax-free gains benefit is being abused to launder money; it will be reduced if such tax free gains were only available after three years.
  • There’s no reason to promote “one year” as a long term investment time frame – like in debt funds or gold, three years is the new long term.
  • The government needs revenue desperately. It will have to raise taxes.

Given this, and given that we have a budget coming next months, here’s what I think should happen:

The Government Should Make Equity Gains Tax Free Only After Three Years

This would make perfect sense, and is quite a logical thing according to me. You buy and wait till three years after you’ve bought, then gains are tax-free. Otherwise, you pay capital gains taxes.

My Goodness, Deepak, are you Stupid? Who the heck will pay short term cap gains till three years?

I didn’t say you would pay short-term gains taxes. You will pay long term capital gains tax after one year. This is 10% of your gains, (or 20% if you index with inflation, whichever is lower).

So if you hold for a year, you still pay a lower tax rate. But it won’t be zero. For Less than a Year, nothing changes – the tax is around 15%.

If you hold for three years, it will be zero tax on gains.

Won’t The Stock Market Tank?

Yes, it will. Firstly people will know that the budget will come in February, but only be applicable after March 31. So if you bought between April 2012 and March 2014, you want to sell your shares and reinvest them. (Why? Because your purchases prior to 2012 will still be tax free as they are three years or more away. If you bought after April 2014, you have to wait one year to get tax-free gains anyway, so no point selling now)

This is probably a small subset of people, but their selling and the general media outrage (because the media is known to get all sentimental about things like this) will cause some damage.

But realization will dawn very soon that:

  • This is not a bad thing
  • Foreigners don’t get impacted at all (since they pay capital gains taxes where they reside, which might be zero anyhow)
  • Some FIIs which were designed to be black money laundering entities will shut shop. But that just means they will be replaced by “proper” entities.

So what if the market tanks? If it’s the right thing to do, it’s what should be done. Markets will go down and up based on what they want.

Will This Happen?

I think it should, but I have no inside information that it will. This is a great time to do it. This government has only four budgets left, really: 2015, 2016, 2017 and 2018.

If you think about it, 2016 or 2017 has to be a blockbuster budget. 2018 will be okay, because that’ll just ride the momentum. So the only budget to do a massive cleanup/kitchen sink is: 2015. That’s now a month away. This budget could be the one that is “horrible”.

If this is a budget to clean up the mess, I think we should increase the term for tax-free long term gains to a holding period of three years.

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  • Raj says:

    Great article Deepak!
    I agree with your suggestion that LT should be defined as 3 years for equity.
    I would go ahead and argue that a small tax rate (say e5%) should apply even to Long Term Cap Gains.
    A lot of Indian promoters have sold off their companies and haven’t paid a dime of tax…..this is long-term detrimental to the country.
    It encourages promoters/entrepreneurs to take their fair income in the form of capital gains rather than income….and these are people who should be paying their ‘fair share’ of tax

    • Varun says:

      I don’t agree here. The value of a share is derived from what you earn and how you create wealth. Companies pay taxes on profits. Left over profits i.e. PAT adds to the value of share. So essentially it is a tax paid value addition. In case I am being taxed for already tax paid income just for converting or changing the shape (from share to cash) is not fair at all.
      I may be in a minority camp, where i say the shares should not be taxed at all if STT is already paid. In share market trading i.e. short term, for every penny I gain, there is a loss someone else pays. I am not creating anything or giving any service that is to say value addition done in trading is NIL. If A gains Rs 100 then B losses Rs 100. A pays tax on Rs 100 and at the same time B gets Rs 100 as deduction or carries forward for adjustment in next years. Net gain in taxes govt can collect is when A earns a profit in short term and pays tax and B gets a loss in long term which is non-adjustable and not carried forward, which is definitely not the case in 99% of transactions. So the govt can free its resources and machinery and implement systems which can take notice on such frauds mentioned instead of complicating the tax systems even further with differential tax rates w.r.t period of holding.
      These frauds can be done only when few people are in total control of the share holding of the company. Such companies where no of shareholders are few and market movements are much beyond the fundamentals, can be tracked easily by running a few queries on the fundamental analysis software. The laws allowing the bonus and splits may be tweaked a bit and large off market transactions wrt listed companies should be checked.

  • yaarth says:

    Please think of some good ideas that can help small investors. FIIs do not pay any tax. Why not initiate it there first? Dividend and Bonus stripping is common. Why not write an article on that? I like your columns but sometimes you go overboard. Equity particpation is at lowest in India public. Suggest some ways for better corporate monitoring.

  • Craytheon says:

    > More investments are coming into the market than ever before.
    But are the investments coming from Indians or FIIs? If the Indian investor base is still too small then the tax benefit has not achieved its goal.

  • K.S Saravanan says:

    If it happens than it will affects the interests of small scale investors. If government wants to earn more taxes than it should imposed for huge volume only it should not affect small investors who likes to saves few bucks

  • Jatin says:

    Do you think black to white money scheme is so high that Gov has to change tax on equity ?
    Nonetheless this post looks like written by terrorist.

    • piyush says:

      Lol.. didnt know terrorists liked discussing long term and short term capital gains tax..
      On a serious note.. yes.. this black to white business is way bigger than you know and can imagine..

  • Murtaza says:

    Don’t scare everyone Deepak.
    People have just started coming back to the markets ….
    And u talk about cleaning mess in the budgets and all that jazz …..

  • nik_patna says:

    By rewarding only long term investment, this will take the steam out of manipulative and speculative sections of the Stock markets which I feel has grown to a disproportionate extent. Taking the speculative component out of an asset class only makes it more resilient and strong. SEBI is simply underpowered, understaffed, and possibly underskilled to match the speed and efficiency of the operators (unlike the US – SEC). e.g., Even an IPO investigation and judgement (DLF case) takes 7 years and I don’t think the delay was just due to congress party interference

  • Sippy says:

    Sometimes I don’t understand the deal with people like you.
    Just there to create noise and nothing much.
    A simple query on Twitter and it does not entice any response whatsoever unless one is a who’s who!

  • D.Rama says:

    Short term gains can be offset by short term losses. If definition of short term is extended from lt. 1 yr to lt. 3 years, it means that much more time to manage losses in one scrip to offset against profits in another. Plus there is also the question of STT, which is currently a major source of revenue for the govt. If there is less trading due to the new laws, surely there will be a fall in STT collections.

    • STT is not very big, it’s of the order of 5,000 – 7,000 cr. which is not much.
      Doubt there will be less trading. I don’ts say make short term gains till three years – I mean tax long term (after 1 year) at the 10% rates and then tax free everything after three years.

      • Varun says:

        If long term is made taxable, there will be issue of carrying forward long term tax losses. These are currently not allowed only because, income from long term shares is non taxable. If they are made taxable, carry forward of long term loss will have to be allowed and govt will loose tax to adjustments against other long term incomes.

  • Bold suggestion Deepak. Maybe it needs to be framed slightly differently to avoid spooking retail investors. The Indian investors’ relationship with equities has been fragile, largely due to unwillingness to stick with it for any period of time. Most dart in and out of stocks on a whim and then complain about poor returns. The reason real estate seems like a heaven-sent investment avenue is the default long-term horizon. So, overall your suggestion will benefit the retail investor by introducing some discipline in the process.
    I’d call it a revision and levy 10% on 1 – 3 years and then 0% for 3 years+. Over time, reduce the delta between STCG and the 10%. Another thought is to give an advantageous tax rate to young professionals (say under 25) to encourage more systematic investing. Earlier they get started, the better their returns and more the confidence in equities as an asset class.

  • Raag says:

    Also, for Gaumata’s sake, let this govt remove all the deductions from Income tax. Current set of deductions unnecessarily forces people to become dishonest. Like inventing rent receipts. Just remove all the deductions and have flat and lower tax rates as the original DTC proposed. I am sure it won’t happen because of various lobbies, particularly because of real estate lobbies and housing finance companies. Sales of apartments will plummet if the housing loan IT benefits are removed. So there.

  • Chirag says:

    Agree totally.. This is a major loophole which was set up with the best of intentions.. Best to plug it now, before any other shenanigans set in..

  • VILAS says:

    The proposed solution does not effectively address the issue of circular trades in shares as the tax is small fraction of the swindled amount
    on the other hand the entire population of equity investors suffers from lower post tax return
    the appropriate step is to reinforce vigilance and punitive steps on those caught doing so and protect honesty

  • Vishal says:

    How illlogical, Deepak. The same trick can be played over 3 years as well, just the pumping up can be done in the last one year, as is being done now. The solution is not to tax local investors, but to tax FIIs and international players, who do not even pay anything on short term gains.

    • Three years is too long for promoters to wait, but yes, they could go that route. I believe it will be easier to detect and that the general impatience will take over.
      I think there’s some talk of taxing international investors based on whether they will be taxed in their home jurisdiction. I don’t see that happening immediately, but the tax treaties will be renegotiated. One clear way to get this crap out is to demand complete KYC of all p-notes, sub-accounts etc. which could lead to a lot of foreign investors getting irritated too. It would be a good idea to plug this too.

  • Deepak,
    Your point is well taken but I have a slightly different suggestion. Keep the LT gains tax free after 1 year but put a slab on the gains for a Financial Year say 1 crore. So, it means LT gains till 1 crore will be tax free and above that they will be taxed ( say at 10% ). Surely money laundering through this route will not make sense with the 1 crore restriction and small investors will not be impacted too.