The principle of horizontal equity in taxation predicates that passive incomes (such as from capital gains on investments) and active incomes (such as from business profits or salaries/wages) should be dealt similar tax treatment. Similarly, returns on capital and returns from labour should be taxed on comparable terms.
However, in a globalised world where there is seamless movement of capital, capital-deficit economies seek to attract capital to their markets to provide liquidity and depth besides facilitating domestic listings. In such a scenario, tax on capital gains from transfer of listed shares becomes a matter of competitive choice given rates are one of the factors in investors’ ex ante calculations of post-tax returns while allocating capital to emerging markets like India. This is by no means the only factor, as other comparative factors like the real growth of the economy, expected performance of financial markets, regulatory environment, quality of corporate governance of domestic companies, rule of law, stable and predictable government policies, ease of operation, expected returns from other emerging markets and the cost of risk-free capital are equally important.
Given capital gains tax is a critical factor for investors, let’s look at the current Indian regime. Since 2004, all transactions for listed shares on exchanges are subject to a securities transaction tax (STT), which is essentially an indirect tax as it bears no relation to the capital gains from the transaction. Capital gains taxation is based on taxing gains held for longer periods (long-term gains) at a rate lower than those held for shorter periods (short-term gains). Following the introduction of STT, the Income-Tax Act was amended to exempt long-term capital gains (LTCG) arising from transfer of listed shares, since they are subject to STT. The holding period for the listed share-sale to qualify as a LTCG is 12 months (as compared to 24 months for unlisted shares and 36 months for other classes of assets).
The lion’s share of foreign investment in Indian capital markets is from foreign institutional investors (FIIs), many of which are large investment funds. Since 1993, the law outlined a separate taxation regime for FIIs and, after modifying it post the introduction of STT, it is as follows:
*short-term capital gains (STCG) on listed shares (held for 12 months or less) is taxed at 15% (and subject to STT);
*LTCG on listed shares (held for more than 12 months) exempt from tax (and subject to STT);
* STCG on unlisted shares (held for 24 months or less) taxed at 30%; and
*LTCG on unlisted shares (held for more than 24 months) taxed at 10%.
It is fair to conclude that India has tweaked its tax policy to attract capital. Now, except for LTCG on unlisted securities, the taxation regime is the same for FIIs and domestic investors.
Unlike India, most countries with active stock markets don’t tax capital gains on listed shares in the case the transferrer is an FII. Thus, there is a ‘no capital gains tax for portfolio investments in listed securities’ for non-resident investors (‘portfolio investments’ generally mean less that 10% shareholding in a listed company). India, however, does tax such gains under its tax law (that applies to both resident and foreign investors) if such shares are held for 12 months or less (at 15%), besides garnering STT (which, in FY17, will be in excess of R7,000 crore). While the taxation of capital gains on listed shares is lighter than that for unlisted shares and debt securities, these other asset classes are not subject to STT.
FIIs investing in India have adjusted to the STT regime alongside a nil rate for LTCG and a 15% rate for STCG due to the ease in terms of tax collection and administration. Over the years, a major concern of the Indian administration was FIIs (and other non-residents) investing via Mauritius, Singapore and Cyprus in Indian capital markets. In the bilateral tax treaties/protocols India signed with the three countries, it had given up the right to tax capital gains as such gains were taxed only in the country in which the FII was resident.
Since these countries were not taxing such capital gains under their domestic tax laws, such income remained untaxed in both jurisdictions except for the STT paid in India. This is the reason why a large part of India’s foreign investment (in listed and unlisted securities of Indian companies) emanates from these countries, as global investors preferred to set up legal structures in these locations to get the highest possible post-tax returns on their investments. The Indian tax administration was also concerned about round-tripping of domestic capital through these jurisdictions, done to take advantage of the nil tax regime on capital gains. In 2016, these three treaties/protocols have been renegotiated (with grandfathering and transition provisions) such that investors from these three jurisdictions will now be subject to India’s capital gains tax regime. Given that the ‘nil’ capital gains tax regime for non-resident investors in India’s capital markets has now been done away with, and there is level playing field as far as the capital gains tax regime is concerned, it would not be opportune to change the regime.
One important and persisting tax-evasion concern for policymakers is the circulation of unaccounted income by misusing capital gains exemption in case of LTCG on listed securities through the trading of ‘penny stocks’ (low cap, thinly traded shares), whose listed price can be manipulated. This can be addressed by excluding such penny stocks from the specified ‘listed shares’, which are eligible for exemption from LTCG tax.
Butani is partner, and Dikshit, formerly joint secretary, GoI, is of-counsel, BMR Associates LLP.
Views are personal