Investment gains: Untangling the tax knot

After several missed deadlines, the task force for drafting the new direct tax code is expected to finally submit its report by February 2019 end. This should pave the way for an eventual makeover of the Income Tax Act, 1961. The new law is expected to be simpler, more equitable, and encourage tax compliance. It’s an idea that has been in the works for nearly a decade.

The task force, while dealing with the broad contours of income tax law reform, should also devote time and attention to set right a veritable madhouse — the taxation of gains on sale of various asset classes.

Different holding periods to qualify for concessional tax treatment, different tax rates on gains, different indexation (readjustment of cost to adjust for inflation) rules, different tax breaks and more — it’s a complex regime often devoid of logic and fairness. While convoluted rules may help tax practitioners, it’s troublesome for ordinary investors, and could result in sub-optimal investment choices. It’s time for simplicity, consistency and fairness.

Different holding periods

The differences start right from the holding period of the asset for the gains on their sale to qualify as long-term capital gains (LTCG), thus becoming eligible for lower tax rates. Consider five popular asset classes of an average investor — equity shares, debt instruments, mutual funds, real estate and gold.

Gains on listed equity shares and listed bonds are considered LTCG if the asset is held for more than 12 months. For real estate, the holding period is 24 months (it was 36 months until Budget 2017). On gold, the holding period is 36 months. Equity mutual funds must be held for more than 12 months for gains to qualify as long-term while debt mutual funds must be held for more than 36 months. There is little logic for holding periods being different across asset classes and even within the same asset class.

The argument that investments in financial assets need to be encouraged over physical assets is flawed and paternalistic — asset allocation is not a one-size-fits-all option and should best be left to investor choice. What’s more, why should the holding period be different for equity mutual funds and debt mutual funds — both financial assets. Or for real estate and gold — both physical assets?

Over the years, lobbying rather than logic has driven many changes. For instance, the holding period for debt mutual funds was increased from 12 months to 36 months to ring-fence banks worried about losing their deposit base.

Why can’t there be a single, standard holding period across asset classes for gains to qualify as LTCG? If the intent is to nudge investors to hold on to investments for the long term, cues about the holding period are available elsewhere in the tax book itself. For instance, the Section 80C tax break is available on equity linked savings schemes (ELSS) that are locked in for 36 months.

Different rates

Next, the difference in tax rates on gains is patently unfair. The powers-that-be, it seems, have an enduring soft spot for some investments — equity and investment-cum-insurance products being the favourites. After nearly a decade-and-half of enjoying tax exemption, Budget 2018 finally imposed 10 per cent tax on LTCG above ₹1 lakh a year on listed equity shares and equity mutual funds.

The stock market threw a tantrum but this tax was an essential first step to end the mollycoddling of equity. There was little fairness in equity gains being given tax exemption, when income from debt instruments such as bank fixed deposits, the mainstay of a chunk of the population, does not get any.

Even now, gains on equity and equity mutual funds enjoy sweetheart tax rates. LTCG on equity is now taxed at 10 per cent without indexation, while short-term capital gains (STCG) continues to be taxed at a concessional rate of 15 per cent.

In contrast, STCG on other asset classes such as bonds, real estate, gold and debt mutual funds are taxed at the investor’s slab rates (5, 20, or 30 per cent) while LTCG is taxed at 20 per cent after indexation. It’s time to bring tax rates on equity gains on par with other avenues.

Also, it is inexplicable why gains on bundled products such as unit-linked insurance plans (ULIPs) should enjoy tax exemption when other investments such as mutual funds are being taxed. ULIPS are essentially market-linked investment products with a sprinkling of insurance. Such unjustified differences in the tax regime result in sub-optimal choices, merely to take advantage of tax arbitrage opportunities.

Besides, while investors in mutual funds have to pay tax even on notional gains when they switch from one scheme to other (say mid-cap to large-cap), or from one plan to another (say regular to direct), such shifts are permitted without any tax incidence in ULIPs.

It must be said that equity, otherwise a favourite child, gets the short end of the stick when it comes to indexation of cost to compute gains. Unlike tax on LTCG on other asset classes such as real estate, gold and debt mutual funds, the tax on LTCG on equity is without allowing the benefit of indexation. Sure, the LTCG tax on equity at 10 per cent is much lower than the 20 per cent tax rate on other asset classes when indexation is allowed.

But cost indexation of gains to compute LTCG is a fair principle that results in taxing only real, inflation-adjusted returns. This principle also leaves open the prospect of long-term capital loss in the future, if inflation runs high. Equity investors should also be allowed the option of cost indexation, even if it means a higher taxation rate. Also, securities transaction tax (STT) should be scrapped. It is unfair if an equity investor has to pay LTCG tax and also STT.

Other mysteries

Then, there are other puzzles to be cracked. Why, for instance, is LTCG tax on only some investments such as house property allowed to be avoided through reinvestment of gains in specified bonds? Also, why is the holding period of bonus shares considered from their date of allotment and not from the date of acquisition of the original shares?

Bonus share issue is just an accounting adjustment of reserves and share capital, and not a fresh purchase of shares. Can the task force discern a method in the madness?

COMMENT NOW