Abolish LTCG tax, incentivise investors

Taxation of capital gains is the most complex and confusing regime in India.

By TV Mohandas Pai & S Krishnan

The Covid-19 pandemic has disrupted the Indian economy in a significant way. Various agencies estimate India’s growth during FY21 to be the lowest since liberalisation in the 1990s. Unemployment has increased, salary cuts and lay-offs are visible, consumption has decreased, there is erosion of investors’ wealth in equity of more than Rs 20 lakh crore since March 2020, real estate market is down, and the mood is very depressing.

In response, PM Narendra Modi announced a stimulus package of Rs 20 lakh crore—equivalent to almost 10% of India’s GDP. He also laid down his vision of making India self-reliant (Atmanirbhar Bharat). While the government has taken care of the bottom 60% of the society, the rest are deeply hurt with no succour! We need some incentives in stimulus-2 for this section of citizens and to restart investments again.

India has seen seminal reforms in capital markets over the last decade. Our secondary markets are in the top 3 on trading volume, regulations, liquidity and risk management. Our derivative market is in the top 2. The big challenge is to improve access to capital for our innovators and start-ups. India has the third-largest start-up ecosystem (~50,000 start-ups and 39 unicorns, creating a value of $170 billion). It is a tragedy that only 10% of the capital invested in start-ups between 2014 and 2020 is from India. For Bharat to become Atmanirbhar, Indian capital should participate in funding start-ups in a big way.

A complex, unfriendly tax system is a big reasons why Indian start-ups have relocated their headquarters outside India. We have a perverse tax system that penalises investing in unlisted companies with a higher long-term capital gains (LTCG) tax. Greater the risk, higher the tax! Individual investors having an income above Rs 5 crore have to pay LTCG tax of 28.5%, including 37% surcharge, on LTCG from unlisted securities. Perversely, the enhanced surcharge of 25% and 37% does not apply on LTCG from listed securities and on FIIs. Maximum LTCG tax on listed shares is about 12%, including maximum surcharge of 15%. Thus, investors earning over Rs 5 crore bear a higher tax impact of 16.5% on LTCG from unlisted shares (28.5%) as compared to LTCG from listed shares (12%). This difference of 16.5% is higher than maximum LTCG tax rate of 12% on listed securities. And nobody knows the reason for this discrimination!

Former finance minister P Chidambaram abolished LTCG tax on listed equity in FY05 and introduced the Securities Transaction Tax (STT) instead. The STT collected in FY20 was Rs 11,000 crore, almost the same amount as LTCG tax on individuals! When finance minister Arun Jaitley reintroduced LTCG tax on listed equity shares and equity mutual fund units from FY19, the STT continued, resulting in double taxation. Abolition of LTCG tax will remove this double taxation and enable investors to choose investments based on risk and return instead of being driven by tax considerations.

Indian investors have begun to invest in digital gold such as exchange-traded funds and mutual funds, as an independent asset class for diversification of risk and return. The Indian gold ETF market is valued at about $1 billion and about 60% of the investments are made by individuals. Gold ETFs combine the flexibility of stock investment and ownership of physical gold since units can be redeemed in physical gold beyond a certain quantity. Gold MFs provide the flexibility of investing in small amounts through SIPs and withdrawals too. The government launched the Sovereign Gold Bond (SBG) scheme in November 2015 under the Gold Monetisation Scheme. SGB investors earn returns linked to gold price and a fixed interest of 2.5% per annum payable semi-annually on the amount of initial investment.

At present, India’s annual gold consumption is 800-900 tonnes, of which about 750 tonnes is imported. Rising popularity of digital gold in ETFs, MFs and SGBs will reduce the demand for physical gold for investment. Capital appreciation in SGBs is tax-exempt at the time of redemption after eight years while this exemption does not apply to capital appreciation in digital gold. Extending the LTCG tax exemption to gold ETFs and MFs would make investments in digital gold more attractive and reduce imports of physical gold. This will help further reduce the trade and current account deficit and enable Bharat to become Atmanirbhar.

The economic downturn consequent to Covid-19 has increased unemployment and uncertainty over job security. Capital protection is the consequent reaction. Homebuyers are deferring decisions to buy. Real estate developers are too cash-strapped to complete projects, with minuscule fresh bookings. The real estate sector, India’s second-largest employer, is down in the dumps right now. It is reported that housing sales in nine major cities declined by 26% from January to March 2020. The return on investment in residential real estate has dropped significantly for investors, more so when compared to other forms of investment such as MFs and digital gold. Real estate was a parking ground for black money before DeMo, RERA and the NBFC crisis. It is reported that in cities like Delhi, even now, black money is being used to fund land purchases. Abolishing LTCG on sale of land, buildings, apartments and houses will disincentivise purchase of land using black money and clean up the entire system. This will generate demand for houses and apartments, increase employment, incentivise citizens to register the correct amount paid for real estate transactions, and over five years the use of black money can be almost eliminated.

The amount of LTCG generated in India is very low compared to salary or business/professional income. CBDT’s Income Tax Return Statistics reveals that LTCG in FY18 was just Rs 1.42 lakh crore, out of the total income of Rs 53.39 lakh crore. LTCG from all taxpayers averages only 2.6% of the total income generated from all sources, over FY15-18.

Taxation of capital gains is the most complex and confusing regime in India. Some specified categories of long-term capital assets get the benefit of cost inflation indexation whereby the base cost of the asset is increased by the ratio of inflation in the year of sale and purchase. Similarly, the STT is applicable only for some assets. If the STT is not paid, the tax rate increases. The accompanying table highlights the differences in the holding period and the tax rates for various types of capital assets and the associated complexity.

Use of black money still prevails in gold and real estate investments. Abolition of LTCG tax on digital gold and real estate will lead to a significant reduction in the use of black money and generate demand for housing. India needs to formalise the financial system. All investments in financial assets should be considered as long-term capital assets after 12 months and other assets after 24 months. Corporate tax rates were reduced to 25% last year. The best way to cleanse discrimination in capital gains regime is to abolish LTCG tax during this Covid-19 crisis. The loss of revenue from abolition of LTCG is minuscule compared to the benefits generated. Abolition of LTCG tax will incentivise taxpayers to record all transactions fully, kick-start investment, and create jobs.

Pai is chairman, Aarin Capital Partners, and Krishnan is a tax consultant.

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