Budget 2018: Long-term capital gains on equities—is a bird in hand better?

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What happens if, in the forthcoming Union Budget 2018, a tax is reinstated on long-term capital gains (LTCG) on listed shares? After an initial shock, the stock markets should stabilize. Domestic investors will realize that equities yield better post-tax returns than other asset classes and India will continue to be a part of the emerging market portfolio of foreign investors.

Once the chaos dies down, the focus will shift to whether revenue increases for the government, which is the underlying objective of any tax proposal.

Here, the question is if LTCG will be imposed in addition to the securities transaction tax (STT) or in place of it. If it is an additional levy, STT collections will continue to add to revenues, while LTCG will be the icing on the top. The worst that can happen is tax collections from equities don’t increase much.

If LTCG replaces STT, then that decision makes sense only if the government is confident of earning more from LTCG than what it makes from STT, on a sustained basis. What could make this difficult? Capital gains are like having a rich mineral underground. Till it is extracted, it is of no use to the tax authorities.

Investors must sell shares they have held for 12 months or more to earn gains and then pay LTCG tax. Now, under STT, they are paying tax when they buy or sell shares. With a tax on long-term sale, investors have one more variable to consider apart from their investment outlook influencing their selling decision. If they decide to delay selling, that delays tax revenue to the exchequer.

Also, when they sell shares, it does not necessarily mean the entire gains get taxed. Indexation will be available. Depending on when they bought the shares, the acquisition cost will be padded up to account for inflation. That can lower the taxable gains. And then there is capital loss as well; they may have shares or other eligible assets that have been sold at a loss. The tax laws allow investors to offset certain losses they have suffered from their gains, to arrive at net gain and therefore the tax payable. If they have losses that have not been set off against gains, they can carry them forward to offset in future years.

The government can’t calculate potential gains and losses in advance, as that depends on the date of purchase, how listed shares move throughout the fiscal year, all of which eventually will determine net gains (or losses) in the taxpayer’s hands. When P. Chidambaram first introduced STT in the 2003-04 budget, he said that his calculation showed STT can result in a win-win situation. That implied that the revenue lost from exempting the tax would be made up by STT.

The thing about STT is that it is collected in both good and bad years for investors. The tax collection happens automatically at source. The tax department would be spending very little money on auditing this revenue, relative to the amount earned. But LTCG relies on the taxpayer to calculate and pay tax, and declare it in the tax returns. Scrutiny requires more effort from the tax department.

Then there is tax planning, a legitimate way used to lower tax liability. In capital gains, this can involve timing the sale of an asset or selling a pool of assets with gains and losses, to lower the tax outgo. There is the illegal side too, which was seen in cases that had come to light before LTCG on listed shares was abolished. Taxpayers with capital gains would enter into sham transactions showing a capital loss, allowing them to lower their net gains.

One might think, with technological advances and the passage of time, such transactions would be difficult today. But even now, one hears of penny stocks being manipulated to take advantage of LTCG tax exemptions. If manipulation can be done for capital gains, it can be done to earn capital losses too. Sure, these can be investigated and penalized but can take years to resolve and recover tax dues.

Another option that has been reported about is an increase in the holding period for listed shares to qualify as long term, from 12 months to 24 months, or even 36 months. That can address the concern of listed shares getting a preferential tax treatment. Whether tax collections will increase meaningfully again depends on the factors mentioned above.

The government is likely to weigh these considerations as it mulls over calls to bring back the tax on LTCG on listed shares.livemint