LTCG tax is a muddled plan that reduces incentive for risk taking, relies only on compliance: View
Posted by: Uma Shashikant on Feb 05, 2018, 10.47 AM IST
Tax on long term capital gains (LTCG) is back. Since a window has now been opened to taxing this income by introducing a flat rate that treats this income differently from other sources of income, it can only be expected that substantial tinkering will happen in this section of the Income Tax Act in future.
Should capital gains be taxed? The argument is that income that an asset generates should be booked to tax, irrespective of whether it is a human asset or a capital asset. Subjecting individual incomes to tax, and exempting capital assets from tax, creates incentives to engage in acquisition of capital assets, without deploying such resources in income generating activity.
The FM alluded to this in his speech. The implementation, however, betrays this intent as we will see. Should there be disincentives to acquiring capital assets? There are two arguments here. The first is about accumulated wealth of the richest in the world, almost completely made up of appreciation in capital assets. What would the wealth of Bill Gates or Warren Buffet be, if not for the value of their equity shares? The argument is that exempting capital gains from tax favours the wealthy.
The second is that appreciation in capital assets is the primary source of bequests, and in regimes like India where estate duties are not levied, exempting capital gains from tax means wealth accumulation is perpetuated and transferred to heirs, without any benefits to the government or society. But capital gains are the primary incentives to entrepreneurship. Investors in equity take on the risk of the business in return for potential appreciation in the value of their investments. Such incentives would diminish if capital gains, especially long term capital gains, are taxed. The low or nil rates of taxes on LTCG enables risky entrepreneurship and extensive participation in equity of emerging businesses by public investors. Given the substantial nature of capital gains, most regimes tax them anyway.
As the FM mentioned, the returns are large enough post-tax too. A case can thus be made to tax capital gains, in normal course. As if they were a source of income and by inclusion in accounts and returns. The Indian story is somewhat different. Capital gains are not taxed at source. By their very nature, they have to be accounted for while preparing the income tax returns, transaction by transaction. The onus of reporting capital gains, and paying taxes on them, is on the taxpayer.
As we now know quite well, tax compliance is poor in India. Many don't care to account for gains meticulously and the number of transactions is so large that the tax authorities find it prohibitively expensive to chase every capital asset transaction and ensure it has been taxed. STT works for this simple reason. It replaces dependence on individual compliance, with a tax at source that was collected with every transaction on the stock exchange.
A mutual fund is structured as a pass-through entity, and will not be impacted, but investors in equity mutual funds will pay 10% tax when they file their returns. Hopefully they will honestly comply. NRIs will find their long term capital gains subject to tax at 10% at source, when they redeem their equity mutual fund unit. The proposed 10% tax does not allow the two provisos in Section 48 of the IT Act. The first one allows non-residents to convert the sale proceeds to the same currency used while investing, before computing capital gains. This enabled taxing capital gains after providing for any losses or gains from changes in the value of the currency. Disallowing this conversion now is a big dampener for foreign investors in Indian markets, especially since the Indian rupee is not convertible and therefore has limited hedging facilities, especially for risky transactions like equity.
The non-availability of proviso two of Section 48, means the long term capital gain in equity is not subject to indexation. This is unlike the long term capital gains taxes on other capital assets. There is also the additional confusion of dividend distribution tax of 10% on equity-oriented mutual fund dividends, which is sure to be contested as inequitable and unfair. The intent of the tax is thus a direct disincentive, which is why the market has reacted negatively. The effect of the tax is to reduce the post-tax return to the investor by imposing a flat levy. However, leaving that levy to the compliance conscientiousness of the taxpayer is inefficient.
A tiny uptick in STT would have garnered more resources with better efficiency, if revenue mobilisation was the requirement. That does not seem to be the case. The wording in the speech and intent in the Finance Bill seem to simply levy a tax on something that seems large, substantial, and accruing to a large number of participants. When charged with the responsibility to use fiscal prowess to direct savings and surplus in a manner that is desirable for development and equity, the policy pronouncements of the government should offer clear direction, rationale and longterm direction. The proposed 10% tax on long term capital gains fails to live up to expectation on all these counts. That it exempts transactions made in International Financial Centres, also smacks of favouritism.
This is clearly not a tax imposed with wealth equity objectives that treats gains in capital assets as taxable in a manner that effectively manages both the incentives and operational efficiency. Given the light nature of the tax which is almost like a sleight of hand, one can expect persistent tinkering with the rate, the exemptions, the operational details and the implementation. That will complicate life for taxpayers, auditors, advisers and accountants. Another instance of nothing gained, but a lot lost in terms of considered thought and action.
The author is Chairperson, Centre for Investment Education and Learning
Disclaimer: The opinions expressed in this column are that of the writer. The facts and opinions expressed here do not reflect the views of www.economictimes.com
This article appeared in Economic Times dated Feb 05, 2018, 10.47 AM IST