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Friday, Jul 09, 2004

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Turnover tax may spook capital gains

S. Vaidya Nathan

An efficient and cost-effective system that would serve the exchequer adeptly has been put in place.

TRADING activity on stock exchanges could be affected by the changes made to the taxation of capital gains and the imposition of a turnover tax. Every transaction in securities would attract a turnover tax of 0.15 per cent, which would be payable by the buyer. As the stock exchange would be responsible for collecting this amount and passing it on the government, an efficient and cost-effective system that would serve the exchequer adeptly has been put in place.

Effectively, the turnover tax would be a tax deduction at source; the government does not run the risk of collections been affected by non-disclosures. It is for this reason that the new system would adequately compensate the reduction in short-term capital gains tax and the abolition of long-term capital gains tax. The capital gains tax suffered the risk of non-disclosures and was difficult to administer.

The turnover tax could also affect trading activity by foreign institutional investors. From August 1998, FIIs have emerged as big traders. Even on days when their inflows are of a moderate size, they are big-time traders. If the government, however, decides to exempt delivery-based trades, FIIs may well emerge as dominant traders as the turnover tax could curb intra-day trades on a non-delivery basis.

The turnover tax may hit trading in the futures and options market in a more pronounced manner than the spot market. Options may take a bigger knock, as the turnover tax would be applicable on the premium as well as the exercise price. The highly leveraged nature of the options and futures market may affect the spot market in the near term.

The reduction in short-term capital tax from 30 per cent to 10 per cent is unlikely to neutralise the negative effect of the turnover tax. This reduction may, however, be viewed more favourably, especially by traders, once the angst over the turnover tax settles down. FIIs, too, would welcome the reduction in short-capital gains tax, as they are aggressive traders.

For long-term investors, the abolition of long-term capital gains tax of 10 per cent is, however, a welcome development. All classes of investors have been placed on an even keel now. Earlier, FIIs and mutual funds were exempt from long-term capital gains tax. This change has also made direct investing in equities attractive. This move has made redundant the exemption that was granted last year for investments made in a specified list of 500 stocks.

In the process, there is no need for investors to cut exposures before a fixed date to avail themselves of the exemption that was introduced last year. The absence of such time-bound pressures to avail themselves of tax benefits would enable investors to make buy-and-sell decisions in a more informed and measured manner without extraneous stress.

The benefit of exemption from long-term capital gains would also be available for debt instruments traded on the stock exchanges. This, too, would be of importance for long-term investors, especially when interest rates decline and fixed-income instruments gain in value. This is, however, unlikely over the next year at least as interest rates may at best be stable at present levels. The more likely denouement is for an upward bias in interest rates.

What the tax break could do is to push the entire market for debt on to the Wholesale Debt Market of the National Stock Exchange. This could provide a push for debt instruments to be listed. The Reserve Bank of India has also been trying to push for listing of debt securities. But the turnover tax could cut into the yield on debt in a more pronounced manner than in the case of equities.

In the case of equities, the tax effect may be muted in bullish market conditions while in sluggish markets; even the 0.15 per cent may become a factor. As transaction costs have dipped sharply over the past five years, especially for institutional investors, the turnover tax could form a sizeable component of their expenses in transacting in securities.

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