STT tweak not to impact volume

Lokeshwarri S K | Updated on July 05, 2019

The Change

The first Budget of Nirmala Sitharaman has not really been well received by the stock market, with the Sensex trading weak, down around 394 points. Surprisingly, this is the first Modi Budget where the capital market has been given a lot of attention. The proposal to increase public shareholding from 25 to 35 per cent appears aimed at increasing liquidity in the stock market and the proposal to increase the statutory limit for foreign portfolio investors from 24 per cent to the sectoral foreign investment limit, and merging the NRI and FPI limits is also aimed at allowing more money to flow into the equity market.

The proposal to initiate a social stock exchange is welcome, but the contours need to be well defined to ensure adequate liquidity.

The tweak to the Securities Transaction Tax is an attempt at ironing out an anomaly. Currently, in option contracts that are exercised, the purchaser has to pay STT at 0.125 per cent of the settlement price. In case the option is not exercised, the seller has to pay STT at the rate of 0.05 per cent on the option premium. Since the settlement price is typically many times the option premium, the higher STT levy was a dis-incentivising exercising of options, leading to price distortions closer to settlement.

The Budget is now proposing to levy Securities Transaction Tax (STT) on the price differential between the settlement and strike price in case of exercise of options. This would remove the anomaly that currently exists in taxing options.

The Background

Equity markets have been quite robust over Modi’s first term. While the initial euphoric rally, based on expectations of fast-paced reforms faded by 2016, the large mutual fund flows into the equity market kept the prices of large-cap stocks elevated, even as mid and small-cap stocks received a pounding in 2018. Earnings growth of India Inc. has, meanwhile, been tepid in Modi 1.0, with sales growth of the companies in the BSE 500 growing at a CAGR of 3.79 per cent between FY14 and FY18 and net profit contracting at -0.41 per cent in this period. It is, therefore, not surprising that the Sensex is trading at a record high PE multiple of 28.8 times currently.

With MF flows into equity being robust, the government did not have to do anything special to incentivise equity investing. The Securities Transaction Tax, that was introduced in 2004 when the tax on long-term capital gains was withdrawn, continues to be in place on both cash and derivative trades, despite the re-introduction of LTCG in 2018 on equity and equity mutual funds in 2018.

The verdict

While the move to increase the public shareholding will improve market liquidity in the long-term, if the proposal is implemented, there could be a rush by promoters to sell their shares to meet the requirement, which can lead to some short-term sell-off.

Allowing higher FPI investments in companies also needs to be thought through since excessive foreign investment is not a good idea in many sectors.

The STT tweak is also not expected to have a material impact on trading volume or tax collections, as a small part of the option trading volume is currently being exercised. While volatility could come down closer to the expiry, the move will not impact in any other way.

Published on July 05, 2019

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