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Economy

Budget 2016: Will The Government Tax Long Term Capital Gains from Stock Markets?

Budget-LTCG2.jpg

Much speculation exists that the government will change the nature of Long Term Capital Gains tax for equities – from zero to…something.

For the record, I would fully support a change in this regard, because I’m against any specific exemptions – they all skew the game in favour of something or the other at the cost of something else. I will explain, but let’s do a bit of a history thing. 

Budget LTCG2

Why Tax Capital Gains? And Why at a Lower Rate?

The government taxes income of any sort. If you earn money as a salary there’s tax on it and you don’t get to account for any expenses. If you put your savings into a bank deposit, the interest you earn is your next year’s income and you’re taxed on that too. If you get money from any source – gambling, lottery, horse races, consultancy, or from a business you run, you will pay tax on it. There are some exemptions like you don’t pay tax when you inherit something, currently, but there was a point that even that tax existed.

Since the government wants to tax you on all or any income, they want to tax you on income you earn when you buy and sell an asset at a profit. An asset is anything that can be bought and sold legally, to simplify it enormously. A house is an asset – so if you buy a house and sell at a higher price, the profit (“capital gain”) is taxable. This applies to houses, gold, mutual funds and so on. 

But at the same time the government wants you to invest, and not just put your money in a safe fixed deposit. So they give you a slightly better deal for investing in risky assets (which is what “capital” assets are supposed to be). When you take that risk, the government doesn’t have to, and you create jobs; that’s the theory, at least.

So capital gains are taxed at a lower rate to encourage such risk taking. The current rate is 20% of such gains. And you also get something you don’t otherwise get – the benefit of inflation indexation. Meaning, if you buy a house at Rs. 100K and sell it for Rs. 200K ten years later, the original Rs. 100K would have been equal to today’s 200K if you assume about 6% inflation a year. That means you actually earned nothing – and the taxman recognizes that and allows you the benefit of inflation, by marking up your buy cost by the level of inflation each year. 

Also read: How to Calculate Long Term Capital Gains Tax

In stocks, we have a different beast. In 2004, the finance minister, Chidambaram, made capital gains tax on stock market transactions go to ZERO. How? He introduced the Securities Transaction Tax (STT) and if you have paid such a tax, there is no tax on capital gains in that transaction. This was supposed to:

  • Help people invest in stocks (a tax incentive)
  • Help collect tax through STT (which is on every transaction, even if it’s short term capital gains or long term)
  • Equate individuals with Foreign Institutions (who come through Mauritius and pay no tax on capital gains in India)

And by and large the second and third incentives have been met.

But Why Do We Need Unending Exemptions?

All exemptions need an end-date. Because when you exempt stock market transactions from long term cap gains taxes, you disincentivize a similar investment in, say, private unlisted companies. This makes no sense – if you create a large private company that’s sold to, say, Google or Reliance, you will pay 20% capital gains tax on the profit. But if you bought shares in a public company and sold them a year later you pay no tax?

The Mauritius guys pay no tax on the private company transaction either, so the “equal” thing is only for public markets.

And then, it would be strange to promote investing in equity over, say, investing in other asset classes; from warrants, to derivatives to even ESOPs, there are different rules that apply.

We need these exemptions to end because they were designed to promote equity investing. They probably have done their job. 

What Is Being Suggested?

One suggestion is that long term capital gains tax only apply on investments that have been held for three years. This is a good starting point, and helps most investors. Anyhow, a house, gold, or other assets get three year holding periods before they are called “long term” assets – why should equity be any different?

Another is to simply remove STT. This is a masterstroke. Imagine the speech: “Dear Speaker, in order to ease the burden on many market participants, we will remove the Securities Transaction Tax with immediate effect. This amounts to a saving of over Rs. XXX crore for investors blah blah…”.

What a statement but it’s impact is humongous. The tax law doesn’t exempt long term capital gains tax from equity investments – the actual wording only exempts long term capital gains tax on which STT is paid. If STT is removed, there is no STT paid, therefore all stock market transactions immediately get long term capital gains (which, in another part of the act, is limited to 10%). This will be a masterstroke – introducing a 10% tax on long term equity gains and making it sound like a benefit! (I removed STT, no?) 

But this might be less likely because a) STT is an easy tax to collect – it comes directly from the exchanges, b) STT applies to everyone including FIIs and mutual funds and c) the impact of a low STT is only felt by short term traders who are not really a large enough number for a popular measure. 

Our View: Let’s Get Rid of Exemptions So We Can Lower Tax Rates

Our tax rates are at 30%+. Why? It’s not like the government earns 30% of GDP. Or even of all the salaries paid; it earns a fraction of that. One of the reasons is that there are so many ludicrous exemptions. From your housing loan interest, to your medical expenditure, to lower capital gains taxes and what not. 

If we removed exemptions, the government could get an equivalent revenue by reducing the tax rate at the same time. I know we don’t trust our government to not take as much as it can, but honestly that’s how a government should be. If exemptions are lower, then tax collection pain is lower (you don’t need all those fancy calculations and tax-saving investment mechanisms and so many tax officials to oversee everything) and therefore the government spend on tax collection is much lesser. 

The downside is that ooh, Foreign Institutional Investors or FIIs don’t pay taxes, but we Indian investors will pay taxes on equity transactions. So what? Mutual funds don’t pay taxes either. Indian ones. Indian insurers don’t pay taxes on capital gains of the stocks held for their customers. Pension funds don’t. Any regulated intermediary entity might not actually pay tax on capital gains – why? As a mutual fund investor, as long as you are invested, you don’t pay any tax. The mutual fund itself can buy and sell many times, and it won’t pay any tax either (it’s not a taxable entity). So technically, a mutual fund can create huge long term gains and not pay taxes.

FIIs too are like that. They are institutions by definition. They don’t pay Indian capital gains taxes, and sometimes they don’t pay taxes in their home countries (exactly like our mutual funds). But when their investors (who may be, say, US residents) take their money out by redemptions, they will pay taxes in their home states. Yes, there are still exemptions here for people who live in Dubai (no tax anyhow) but you get the point here. There is nothing big about an FII not paying tax, because even a DII doesn’t pay tax

Lastly we fear that the market will tank if this tax is introduced. Well, if it were introduced stupidly, like saying it will only apply after April, then yes, I think March will see mas
sive selling so that the current tax regime can be used to the best end. 

But if they are smart they will either:

a) remove STT immediately (so any transaction on the day of the budget or after that will not get charged STT). This means any transaction is immediately taxable.

b) or, they will allow you to mark all your investments as if they were bought on March 31 of 2016. So even if you bought at 10 and current price on 31 March 2016 is 100, your cost price is assumed to be 100. That will not trigger a sale, because you effectively do not have any capital gains at all until April.

Overall, I would welcome to removal of all exemptions (not just this one), and a lower-tax regime. Adding a long term capital gains tax in isolation isn’t going to help that much.  Instead of looking at this as a tax-gaining exercise – it will not yield much in terms of tax revenues – we should consider this as a mechanism to level the playing field. 

We’ve written before that we should take away tax sops for housing. (There are five different ones!)

We’ve written before that the idea of reducing tax exemptions and reducing tax rates is a worthwhile goal.

We recommended making equity gains tax free after three years for the last budget in 2015

These steps may not be popular, but we believe they will help in the long term. 

  • Ramesh says:

    In one go, you lost all my respect. Such crap article I have read for the first time on Capital Mind. What silly logic. Since I see you know nothing about Indian Taxes @overall level, let me show you one red cloth-Agricultural Income OF ANY SORT is 100% tax free since 1947. Try giving some of your valuable suggestion of taxes there and see what happens to you. Crap article.

  • Harsha says:

    I feel it is important for govt. not to keep tinkering with taxes often. People who have patiently waited for the stock markets to gain, holding stock, without booking losses in the bad days, would suffer if govt. brought in LTCG when going in stock markets are good.
    If it was removed for a specific purpose, it should stay removed. Or if it is going to be there it should stay there. No YO-YO business, as it makes life hell for people who calculate post-tax returns.

  • Suresh Vr says:

    Hi Deepak, the reason for removing exemptions and lowering tax rates is appreciative and understandable. But when FIIs, DIIs, Insurance guys are all exempt from capital gains tax on equity shares, why should the retail investor alone be charged? Wont this scare away the retail investor? Does the government want to promote mutual funds at the cost of retail investors? Why should DII enjoy more privilege?

  • Rajvir says:

    I completely disagree with this,this will lead to more bureaucracy and paperwork and lower revenues.
    Government should also exempt STCG and increase STT which is easy to collect and efficient and will involve no additional paperwork.
    So more revenue and less headache for everyone involved.

  • Ashok says:

    This low level exemptions like medical/LTA/HRA/Housing etc just corrupt the middle-classes and should be immediately scrapped. People are busy to generating fake bills, rent receipts, and such just to save a few hundred bucks. Instead the government should simply lower the tax rate and do away with all the exemptions.

  • Hemant says:

    I fully agree with you, however i feel govt should workout about how much they can collect long term capital gains v/s STT collected,to work out what is best.These can be checked with past 3/4 years data.Further i feel they should not tinker with DDT as by asking companies to pay upfront dividend tax is much better.

  • haplessTaxPayer says:

    The Government can only screw the hapless middle class tax payer.
    Will the Govt bother reducing corruption/leakage/inefficiency? No, of course not.
    But what they can do extremely well is squeeze the tax payer even more – so why the hell not.
    In fact, I suggest that the Central Govt make it “Secular” friendly [taking notes from West Bengal Govt] – no exemptions for general caste Hindus.
    Another suggestion for the Baboons, let us have more KYC – monthly updation of KYC should be mandatory from now on.

  • Rama Karupaiah says:

    First let me set the record straight – the constitution allows the govt of the day to levy taxes of all kinds at its discretion, only differentiating btw state list and central list. Frankly there are too many taxes. Direct taxes should only be on income and not on capital; common sense tells you that to discourage capital formation is unwise and it doesn’t matter if it is inherited or earned. When you start to differentiate on this basis that’s when the slope becomes slippery fast.
    Second dividend tax is idiocy; why should income which is taxed become subject to tax on distribution? Remember salaries are taxed because these are deductions allowed against income for taxation. Not so dividends.
    The argument that it is done in other countries is intellectual sloth.
    One more thought – please read S.Gurumurthy’s articles on Indian economy. The man knows economics far better than western educated economists who just refuse to acknowledge that the welfare centralised model followed by western economies will always be subject to boom and bust.

    • Gurumurthy is brilliant in parts – but his recent piece on public sector banks was sloppy and ignored nearly all the important points about banking. So, yeah, not a big fan in general but he has written well.
      Capital Gains taxes make sense – taxing passive income is necessary to incentivize active income as much as passive income. I don’t agree with the fact that this discourages capital formation – in fact most capital formation is in startups and early stage cos where for the most part the equity arrangements have very little tax implications when they are invested in.
      Dividend tax I agree is nuts; and it was introduced to tax people who would otherwise not be taxed (like, for example mutual funds or DIIs – perhaps FIIs might pay dividend taxes,I’m not sure, if they weren’t tax free) Dividends being taxed is double taxation I agree.
      What happens in other countries is a matter of perspective, but cannot be used to justify something just with that argument. I like questioning anything that can be questioned so if it appears I have justified something because Singapore or the US does X then please accept my apologies.

      • Rama Karupaiah says:

        I think you have missed Gurumurthy’s point. One must look at it from the broader point of financial supremacy and geopolitics. Do you think western govts. are going to let big banks go bust? After all they were technically insolvent in 2007/08 and still are; despite all that noise about Dodd- Frank and the need for oversight since the gfc banks have continued with trading/ derivative funding/ junk bond funding albeit more circumspectly. Why do you think ECB is imposing negative rates? And now they are thinking of outlawing cash! Sorry slight deviation!! Bottom line – the US learnt a hard lesson after Enron, one of the consequences of which was the disappearance of Arthur Anderson. Never again will the govt. allow big financial institutions in the US to go bust. Why? Today warfare is not mere military hard assets but also financial domination. That is why despite all the problems in the PSBs Gurumurthy is not advocating adherence to Basel III norms; rather make haste slowly.
        Yes fiscal policy is a tool to influence economic behaviour – unfortunately this more often than naught is misused because fundamental flaws in the infrastructure (financial, physical, legal) have not been dealt with. If there is equality of opportunity and the infrastructure available allows for entrepreneurship capital would not remain passive. Capital gains from the point of view of law of equity is not justified.

        • There’s a lot of crap in that article – we aren’t going to let Indian banks go bust but the foreign banks you mention, they did raise capital and so must our banks. They did have shotgun mergers and that’s what is likely to happen here. The point here is that recognizing losses is important and should be done – this concept of not recognizing losses through prudential requirements is dumb. We need to recognize the losses – in fact what is being requested is not even the full loss, just 20% of it until they have done some kind of recovery! Plus this comparison with other countries is largely unnecessary – because if our argument is the same thing (like Iceland) then some counter will come like oh that cannot be compared, India is unique etc. Sorry but I don’t agree with Gurumurthy on that article at all.

  • Kris says:

    This is not the kind of article we expect from you. Very poor. May be you need a long vacation.

  • Shan says:

    Just focusing on STT or capital gains from stocks is a very narrow view. I agree with taxing capital gains but there needs to be a much deeper thought and clearer vision about this. Sell me the vision and I’ll pay the tax. The short term thinking like ‘Indians are not invested in equities hence let’s make capital gains from listed equities non taxable’ is NOT OK. Stop gap measures create far bigger long term problems. This had been the case in other aspects of politics and administration also which I won’t go in.
    So, is everyone going to pay tax? No? Then why should stock market investors do that?
    The vision should be to remove every single exemption in say 5 years for all. If not, it’s another short term thing – why bother?
    Does the govt dare to take bold steps? If not now then when?

  • Nandan says:

    ..just because the post suggested additional taxation? tolerance folks, tolerance
    Having said that the underlying premise was get rid of exemptions so taxation can be lowered.
    I think every Finance Minister asks his bureaucrats this question each year, but none of the officials would be able to put up a business case to increase taxation in one area only to reduce in others with an aim of additional collections. I think in a difficult democracy driven macro-economy finding such cause & effect requires extreme clarity, solid data, strong conviction and amazing confidence in the Country’s tax administration. are we ready for that yet?
    The other side of the suggestion is that will such taxation really help promote domestic and retail participation in Markets? – I mean India is abysmally low there compared to our usual benchmark China – leave alone the US. Retail participation generates wealth, and helps the masses directly participate in the growth of the economy, besides giving the markets more coverage & depth, thereby reducing volatility by reducing dependence on few large players. Changing Long term or capital gains definitions will surely be a dampener for such objectives
    If we line up competing objectives and priorities, then things become rather clear whether the time has come for change in LTCG definitions – I think we just need to wait for the weekend I guess for this one

  • FB says:

    As someone before me has said, frequent tinkering with tax laws makes life difficult for long term investors. Making LTCG on equity taxable will only serve to divert people either towards real estate (with its lack of transparency and illiquidity) or towards assets like EPF and PPF which frankly may not be sufficient towards building a retirement corpus.
    Though I don’t agree with some of the assumptions behind your article, have to genuinely applaud you for taking the stance given the hostile response you have received from some of the commenters.

    • Thanks. RE is as good (or bad) as stocks, to be honest, and EPF/PPF as the 80C exemption is also deserve to go.
      For example what if the government simply said – we’ll raise the no-tax limit to 4L. No 80C at all. Same effect, much less paperwork!
      Thanks also for your comments – anyone is free to disagree with my comments and short of personal attacks I will not censor any feedback…

  • Dinesh Nagpal says:

    Interesting explanation from your side on why a tax on LTCG is probable and extending it to 3 years just like the case in Real Estate. However, in the case of Real Estate, there is the indexation factor (as you mention) hence, will the Govt offer the same in equities at the time of calculation of taxes? (allow investors to index books every March based on closing prices). Also in the case of Real Estate the income post indexation is taxable only if it is not re-invested in real estate or blocked through RECL / NHAI bonds for 3/5 years. Will the Govt give such incentives here too? Not to forget the 1.50 LAKHS standard deduction for home loan interest. If they do so it will be back to square one, another form of exemption! Moreover, will this not be negative for investments and further fuel trading (which is the last thing what we need for stability in markets). STT is not going for sure, its a huge collection kitty for the Govt plus an easy one. They will never close that window, in fact they will continuously look for further revenue from it. By the way, wasn’t DTC supposed to be on the same lines; removal of LTCG exemption?

    • All capital gains (not just real estate) can be reinvested in RE or in REC/NHAI bonds.
      I think the home loan interest deduction needs to go (or, you should be able to add teh interest to the cost of your house so that when you sell your gain is lesser).
      Btw, indexation will be available for LTCG on equities too – it’s available for all assets…

  • Anand Vaidya says:

    Though I don’t like your recommendation of restoring LTCG taxation, I should say your logic is solid.
    Now, this Clown-Cowboy pair (I mean Gov of India & IT Dept) should announce a Long Term plan and proceed methodically with reducing tax rates alongside eliminating exemptions. That would make sense.
    Now, does the gov have the guts to tax Agricultural Income ? How about eliminating Haj Subsidy? and many other unwarranted subsidies too?

  • Sundar says:

    Warren Buffet said that his Office Assistant pays more tax than what he pays in taxes. The reason was Assistant pays Income Tax while Buffet tweeks his Capital Gains tax.
    In principle Capital Gains tax is not equitable. But no Country will dare to touch their Rich and Powerful who subsist on growing their Wealth through Capital Gains and Estate duty taxes.
    India will also not buck the trend.
    I expect no big shock on this issue in the coming budget.

  • Shailendra says:

    Well..I know people in Bangalore who own more than 50 flats and their number should be in 1000s (maybe a gross exaggeration ) , but you know whom I am pointing to (Reddy’s) . They take rent in cash and are not taxed. Same should be true for other cities as well.
    Why shouldn’t govt try to bring them into tax net rather than trying to sell taxpayer’s kidney?

  • Yatharth says:

    Agree with “In one go, you lost all my respect. Such crap article I have read for the first time on Capital Mind. What silly logic. “

  • RAJESH says:

    Rajesh
    A crap article by Deepak which needs to be condemned coz when stt is easily collected & world markets already in Bear grip LTCG
    reimposition is RIDICULOUS. THANK GOD DEEPAK SHENOY IS NOT IN FINANCE MINISTRY !!

  • Tdv says:

    If stt is removed and capital gain should be part of your total income and normal tax rates should apply. The long term loss should then be allowed to be set off against. Other heads of income.