The Hindu Business Line : Falling short on reason

CAPITAL gains is one of the important heads of income under the Income-Tax Act. Liability to pay capital gain tax arises whenever there is transfer of `capital asset' which results in profit.

The surplus of the consideration received over the cost of acquisition of the capital asset becomes chargeable to tax in the year of transfer.

Capital asset is defined in Section 2(14) of the Act to mean `property of any kind held by an assessee', but specifically excludes certain items enumerated in sub-clauses (I) to (vi) thereof.

Capital assets have been classified as short-term and long-term. The difference in the two is based on the period of holding of the assets. An asset held for not more than 36 months immediately preceding the date of its transfer (12 months in the case of shares and units of the UTI and mutual funds, Section 10(23D)) is a short-term capital asset. An asset which does not fall in this category is a long-term capital asset.

The current scheme

Short-term capital gains (STCG) are charged to tax at the rates in force prescribed in the Finance Act of the year. Long-term capital gains (LTCG) are chargeable to tax in terms of Section 112 of the Act, that is, at 20 per cent after utilising the benefit of indexation.

However, LTCG arising out of the transfer of long-term assets, comprising securities as defined in Section 2(10) of the Securities Contracts (Regulation) Act, 1956 in respect of securities listed in recognised stock exchanges in India, are taxable at 10 per cent if the benefit of indexation is not availed of.

For foreign institutional investors (FIIs), the LTCG and STCG are taxed at 10 per cent (without indexation) and 30 per cent respectively.

Need for change

As per the Explanatory Memorandum to the Finance Bill, 2004 the reason for making changes to the capital gains taxation scheme is to simplify the law. However, the main reason seems to be to check the misuse of tax treaties, especially the one with Mauritius.

If a foreign investor comes via Mauritius and earns capital gain on sale of Indian securities, whether long-term or short-term, the Indo-Mauritian treaty provides that India would not tax such gain. It would be taxed only in the country of residence (Mauritius), and Mauritius does not tax capital gain.

To enjoy this benefit, many Indian taxpayers are routing their security sales through Mauritius.

The changes proposed

The proposal is to levy 0.15 per cent tax on the value of all the transactions of purchase of securities that take place in a recognised stock exchange in India.

This tax will be collected by the stock exchanges from the purchasers of the securities and paid to the exchequer. The provisions relating to the proposed tax are contained in Chapter VII of the Finance Bill and are to be effective from the date the Chapter comes into force.

Further, it is proposed to insert clause (38) in Section 10 of the I-T Act to exempt from tax LTCG arising out of securities sold on the stock exchange. It is also proposed to insert a new Section 111A and amend Section 115AD of the I-T Act, so as to provide that STCG arising from sale of such securities to an investor, including Flls, shall be charged at 10 per cent.

Critique

The new scheme has been, inter alia, introduced mainly to attract foreign investors and make available to them a hassle-free tax regime. However, foreign investors may not find the scheme lucrative as they, under the existing tax treaties, will not be able to avail themselves of tax credit for the transaction tax of 0.15 per cent paid in India.

The transaction tax will push up the costs incurred in buying securities in India. Apart from the proposed tax, the costs include stock exchanges fees, brokerage, service tax (which is being hiked from 8 per cent to 10 per cent) and a 2 per cent cess on service tax. Further, if the transaction results in a gain in the short term, that is, in less than 12 months, 10 per cent capital gains tax would also be payable.

Transaction tax will be payable irrespective of whether the deal results in loss or profit. This would be against the philosophy of the I-T Act. Doing so reduces income-tax to the level of sales tax, which is not permissible in terms of Article 265 of the Constitution.

Income-tax is basically a tax to be paid when one earns income. Under the proposed scheme, even persons suffering losses will be required to pay transaction tax. Further, the rate of 0.15 per cent seems to be quite high.

Sometime back, SEBI had imposed a turnover-based fee on market participants — 0.01 per cent for delivery-based transactions and 0.001 per cent for non-delivery-based transactions.

An additional 0.15 per cent, that is, 15 times more than the existing one for delivery-based and 150 times more for non-delivery based transactions would be a big disincentive for entering into such transactions. The capital market has so far not reacted favourably to this tax.

Further, the securities transaction tax is not expected to increase market efficiency. If the capital gains tax involves complexities, these need to be sorted out. For these, the tax need not be abolished. Curing a headache does not lie in cutting off the head itself.

Despite this change, Mauritius will continue to be useful for short-term investors. LTCG arising out of securities sold on stock exchanges (listed ones) will now become tax-free.

Hence, the Mauritius route will not be necessary for such gains. Short-term gains can still be avoided by routing the transactions through Mauritius. Thus, the malady sought to be got rid of will still continue for such gains.

The proposed scheme seems to have been introduced without any empirical study regarding its effects of tax revenues. No figures have been given about the likely revenue gain through transaction tax.

Similarly, no reasons have been given as to why LTCG have been made tax-free and the rate on short-term gains reduced to a mere 10 per cent even as the law, at present, taxes these at the rates applicable.

Tax policies cannot be changed according to the whims of Finance Ministers. The country is entitled to know what prompted the change and the revenue impact of the same.

Unfortunately, the Budget is silent on these, and so is the Explanatory Memorandum.

(The author is a former chairman of CBDT.)