Taxation of long term capital gains (LTCG) arising from sale of listed equities has been a current subject of discussion ever since such gains were first fully exempted from tax liability from FY05.
Every year pre-budget speculations would focus on this exemption and the consequences for the equity markets if it is withdrawn. A mere hint of withdrawal of this exemption has made markets jittery. Finally, the exemption was partially withdrawn with effect from FY19.
It may be pertinent to note that in most jurisdictions differential treatment is prescribed for the taxation of capital gains. However, no major country makes a distinction between equity shares and other assets for taxing the capital gains; and only a few (mostly tax havens) provide full tax exemption to the capital gains.
The debates in India over LTCGs are usually emotional and focus on ‘market sentiments’, rather than providing any rationale for providing such exemption. Since the government is under tremendous pressure to exempt LTCG on equity shares, it is worthwhile to hear the devil's arguments against the merits of LTCG exemption.
In my view, the exemption to the listed equities from LTCG is an anomaly, which the government has done well to remove.
Misused for money laundering
It is common knowledge in market place that the LTCG exemption for tax has been abundantly misused for money laundering purposes. In fact in past couple of years, the regulator and taxation authorities have also initiated action in many cases for misuse of LTCG taxation provision for money laundering purposes.
The argument that exemption for LTCG arising on ‘sale of equity shares’ motivates investment in risk capital may not be tenable after all. It must be appreciated that the activity of buying and selling equity shares in secondary market
per se does not provide any risk capital to the underlying businesses. It in effect just changes the beneficial owner of the business without impacting the business in any manner whatsoever.
The question that needs to be analysed and answered is why should someone (seller of shares) who is actually transferring his risk to someone else (buyer of shares), be rewarded with tax concessions? Besides, it may be difficult to support the argument that holding a listed stock for more than one year in any way helps the economy or the capital markets.
It is widely believed that holding equity shares for longer term usually enhance the chances of higher returns for the investor. The question could be "why the investors should be given tax breaks for enhancing his return prospects?
One could appreciate the ‘development of capital market’ argument in case of investing in IPOs, PE funds, or venture funds, as in such cases the businesses get the much-needed risk capital from investors. But the secondary market transactions do certainly not pass this muster.
The incentive for longer term holding period has may also not be adequately justified by the ‘improving market liquidity or minimising market volatility’ argument. There is absolutely no evidence to suggest that market liquidity improved or volatility reduced during 2004-20018 due to exemption provided to LTCG.
Abolition of STT
To the contrary, consider the following:
(a) The day traders, jobbers and market makers who provide the much-needed liquidity to our shallow markets, and hence motivate risk taking. These market participants are in fact looked down as undesirable elements in the market and subjected to ‘sin tax’ in the form of STT, instead of being rewarded with meaningful tax incentives.
Abolition of Securities Transaction Tax (STT) may actually lead to material rise in daily volumes and deeper markets, thereby materially lowering the transaction cost and market volatility.
(b) In the absence of a functional retail debt market, corporates depend heavily on ‘fixed deposits’ from household investors for meeting their short term fund requirements. These deposits are fully unsecured and entail high risk for investors, in lieu of marginally higher interest rates as compared to bank lending rates.
Providers of unsecured debt take much higher risk as compared to the equity holders and therefore deserve more tax incentives.
In my view, full tax exemption to the interest earned on corporate fixed deposit of three years or NCD of five years or higher maturity may help the businesses and markets much more than the LTCG concession on sale of equity shares held for more than 12 months.
Vijay Kumar Gaba explores the treasure you know as India, and shares his experiences and observations about social, economic and cultural events and conditions. He contributes his pennies to the society as Director, Equal India Foundation.