Union Budget 2021 India: Abolish the enhanced surcharge on capital gains from unlisted shares and Reduce the holding period for unlisted equity shares to qualify as long-term capital asset
By TV Mohandas Pai & S Krishnan
Indian Union Budget 2021-22: PM Narendra Modi announced a seed fund of Rs 1,000 crore for startups to set up and grow their businesses, at Startup India’s international summit ‘Prarambh’. He said the government is taking important steps to ensure that India’s startups don’t face a shortage of capital. He indicated that startups are already receiving assistance to raise equity capital through the Fund of Funds. To supplement this, the government will also enable startups to raise debt capital by providing a guarantee. India’s goal for the next five years will be to enable startups to become unicorns.
This is a laudable initiative by the Centre. India currently has the third-largest startup ecosystem in the world, with around 50,000 startups and 42 unicorns creating a value of $170 billion and 800,000 jobs! Over 20 unicorns are domiciled overseas, and almost all of them have very high foreign holding due to onerous Indian regulations! Consequent to good government policy in the past few years, about 721 AIFs have been set up in India with a capital commitment of $55 billion. It is a tragedy, though, that only 10% of the capital invested in startups between 2014 and 2020 ($70 billion) is from India. India targets 100,000 startups, 100 unicorns, 32,50,000 jobs by 2025, but due to lack of adequate Indian investments, India is well on its way to becoming a Digital Colony!
To encourage high-income earners in India to invest in startups, the Centre should remove the discrimination in taxation faced by investors in startups in India and the MSMEs. The Finance (No.2) Act 2019 imposed a higher surcharge on individuals with taxable income beyond Rs 2 crore. The effective income tax (I-T) rate for individuals with taxable income between Rs 2-5 crore increased to 39%, and for those above Rs 5 crore, to 42.7%. This enhanced surcharge was later withdrawn on short- and long-term capital gains from listed equity shares on which securities transaction tax (STT) is paid and on short- and long-term capital gains generated by FIIs on the transfer of securities (both listed and unlisted).
As a result, resident individuals are required to pay an enhanced surcharge on short- and long-term capital gains generated from the transfer of unlisted shares, which is not applicable to FIIs. This creates discrimination against high-income earners in India who invest in startups. To encourage the growth of Indian capital and to prevent India from becoming a digital colony, the enhanced surcharge on capital gains from unlisted shares should be abolished, as has been done for FIIs!
There is blatant discrimination on the taxation of listed and unlisted equity shares. Investments in unlisted equity shares carry higher risks and lower liquidity compared to listed equity shares. However, to qualify as a long-term capital asset, the holding period is 24 months for unlisted shares compared to 12 months for listed shares. LTCG tax on the sale of listed shares is 10% while it is 20% for unlisted shares. Even non-residents pay LTCG tax at 10% on unlisted shares! Considering that angel investors having high income generally invest in startup companies, the LTCG tax for them after surcharge and cess would be over 28%.
There is no rationale for this difference. To provide an incentive to domestic investors to set aside a portion of their investment corpus for unlisted companies, the holding period for unlisted equity shares should be reduced to 12 months to qualify as a long-term capital asset and the LTCG tax on the sale of unlisted shares should be reduced to 10%.
The accompanying graphic shows the additional instances where foreign investors enjoy a concessional tax rate.
To curb the discrimination between foreign and domestic investors, who remain invested in India at all times, dividend and interest income should be taxed at the slab rates or 20% (ex surcharge and cess), whichever is lower. Consequently, the maximum tax rate applicable to dividend and interest income should be 20% (excluding surcharge and cess) to all tax resident in India.
A large number of MSMEs in India are registered as partnership firms and Limited Liability Partnerships (LLP). The Finance Act, 2020, provided an option to individuals, HUFs and companies to switch over to a lower tax regime from FY21 and onwards if their total income is computed without claiming specified exemptions or deductions. There is also no requirement to pay minimum alternative tax (MAT) for companies under the new tax rates of 15% and 22%.
However, the rates were not reduced for partnership firms/LLPs. By reducing the base I-T rate for them without being eligible to specified exemptions or deductions, all enterprises in India will have a common base tax rate of 22%.
Remuneration paid by a partnership firm or an LLP to its partners, according to the terms of the partnership deed exceeding certain defined limits isn’t allowed as a deduction to the partnership firm or the LLP.
However, remuneration paid by a company to employees is allowed as a deduction without any limits, and the employees are liable to pay income-tax on such remuneration. A partnership firm/LLP should be allowed to claim full deduction on remuneration paid to its working partners, and the partners should be liable to pay income-tax on such remuneration received.
To attract foreign funds at a lower cost, the FM extended the 5% withholding tax concession up to June 30, 2023, to FPIs and Qualified Foreign Investors, on interest payments from rupee-denominated bonds issued by Indian firms, G-secs and municipal bonds. The period of 5% withholding tax concession for interest payment on money borrowed from and bonds issued to non-residents was also extended up to June 30, 2023.
However, the TDS rates on various payments in India have not been reduced after the I-T rates were reduced. These should be aligned with the lower I-T rates applicable to individuals and firms to prevent unnecessary refunds. The TDS rates should be reduced to 5% in case of interest and dividend income, insurance commission payable under section 194D, payment in respect of deposits under National Savings Scheme, rent from land, building, furniture or fitting, fees for professional or technical services, income in respect of units payable to a resident person, certain income from units of a business trust and investment fund paying an income to a unitholder. The exemption threshold for TDS rates should be increased to Rs 50,000 per year. This won’t lead to lower revenues, it will only reduce the need to claim large refunds later and improve taxpayers’ cash flows.
There is double taxation on capital gains in India. Former finance minister, P Chidambaram abolished LTCG tax on listed equity shares and equity mutual fund units in FY 2004-05 and introduced STT instead. STT collected in FY20 was Rs 11,000 crore, almost the same amount as LTCG tax on individuals! When former FM, Arun Jaitley reintroduced the LTCG tax on listed equity shares and equity mutual fund units from FY19, STT continued, resulting in double taxation. An 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.
The Income Tax Return Statistics published by the CBDT reveals that income from LTCG in FY18 was just Rs 1.42 lakh crore out of the gross total income of Rs 51.33 lakh crore. The LTCG from all taxpayers averages only 2.60% of the total income generated from all sources, over the four financial years from 2015 to 2018. The loss of revenue from the abolition of LTCG is minuscule compared to the benefits generated. Abolition of LTCG tax will incentivise taxpayers to record all transactions fully, kickstart investment, create jobs and improve positivity.
An AIF is defined under the SEBI (AIF) Regulations, 2012 as any private pooled investment vehicle which collects funds from investors, whether Indian or foreign, for investing it in accordance with a defined investment policy for the benefit of investors. SEBI regulations do not permit Category I and II AIFs to undertake business activities. The I-T Act specifically provides for taxation of business income of an otherwise exempt investment fund!
The I-T authorities haven’t issued specific guidelines on the determination of business income of an investment fund. This causes uncertainty in income characterisation for an AIF, and thereby, its taxation. All gains from investments in financial instruments in public markets in India are taxed as “Capital Gains”. Given Category I and II AIFs can’t undertake business activities, a reference to computation of profits/gains from business or profession isn’t relevant and must be removed for taxation of investment funds.
For an atmanirbhar budget, the FM must abolish the enhanced surcharge on capital gains from unlisted shares, reduce holding period for unlisted equity shares to 12 months to qualify as a long-term capital asset, reduce LTCG tax on the sale of unlisted shares to 10%, abolish LTCG tax on the sale of listed securities, reduce base I-T rate of partnership firms and LLPs to 22%, limit the maximum tax rate applicable to dividend and interest income to 20% (ex surcharge and cess) and reduce the TDS rates to 5%.
Pai is chairman, Aarin Capital Partners and Krishnan is a tax consultant. Views are personal