The capital gains tax conundrum

Capital gains tax suffers from varied tax rates or holding periods for different types of instruments even though they fall within the same asset class

Finance Minister Nirmala Sitharaman recently emphasised that she will be presenting merely a vote on account in February, with no “spectacular” announcements. However, bringing tax reforms to facilitate investments has been an ongoing priority for the government and it is fully cognisant of the areas that need attention. Capital gains taxation is one such aspect, where simplification and rationalisation are long overdue.

Globally, capital gains tax treatment varies depending on a country’s tax policy for encouraging investments, inflation level and need for simplicity. For instance, while Singapore does not tax capital gains at all, the US does not tax non-residents on capital gains on listed securities there.

The present capital gains tax structure in India is highly complex. It suffers from varied tax rates or holding periods for different types of instruments even though they fall within the same asset class. For instance, within financial assets, listed shares and equity-oriented mutual funds have 12 months’ holding period to qualify for long-term capital gains (LTCG). Other financial assets like unlisted shares require a holding period of 24 months and yet others like listed units of real estate investment trusts (REITs) and infrastructure investment trusts (InVITs) and debt-oriented mutual funds need 36 months to qualify for LTCG.

The capital gains tax rates vary from 10 per cent to 30 per cent. While the sale of equity shares/units of equity-oriented funds attracts 10 per cent tax on LTCG above ~1 lakh, other financial assets are subject to a higher 20 per cent tax rate. The tax rates also differ for residents and non-residents, the former subject to a higher LTCG tax rate of 20 per cent on sale of unlisted securities whereas the latter enjoy an LTCG rate of 10 per cent on the same instruments.

The indexation benefit is denied in cases of LTCG from transfer of an equity share, or a unit of an equity-oriented fund or a unit of a business trust where LTCG rate is 10 per cent. The same is the case for LTCG on unlisted shares for non-residents. But bonds or debentures, where LTCG is higher at 20 per cent for residents, are also denied indexation benefits despite the real return on such instruments being lower due to the effect of inflation.

Such complexity can be simplified by providing a well-defined structure for taxation of capital gains. The holding period to qualify as LTCG for all types of financial assets could be aligned to a uniform period so that investment decisions are not affected by artificial distinctions in assets’ holding period. The financial assets should cover all, such as listed and unlisted equity/preference shares, equity-oriented mutual funds and instruments such as REIT/InVIT units, and other financial assets like debt-oriented mutual fund units, bonds and debentures. The LTCG tax rate can be aligned at 10 per cent and short-term capital gains (STCG) tax at 15 per cent for all types of financial assets. Indexation benefits may not be needed for LTCG on financial assets if the rates and holding period are aligned.

There are other anomalies which, once addressed, will help in rationalisation of the law, reduce litigation, and provide relief to taxpayers. Some of these issues are discussed below.

The method prescribed for computation of fair market value (FMV) in respect of the anti-abuse provision for the transfer of unlisted shares is normative, whereas the actual transaction value may be lower due to bona fide commercial reasons. In the case of immovable property, the law allows a delta/tolerance limit of 10 per cent for difference between stamp duty value and actual consideration for applying the anti-abuse provision. However, no such margin is allowed for the transfer of unlisted shares, which could result in a higher capital gains tax burden on the taxpayer. Amending the provisions to allow valuation of shares by a recognised merchant banker or empowering the adjudicating officer to refer the valuation to a recognised government valuer for determining FMV will avoid additional tax burden in genuine cases. Further, a delta/tolerance limit of at least 10 per cent of actual consideration should be provided for the transfer of unlisted shares, just as for immovable property.

The applicability of buy-back tax (BBT) to listed companies poses a practical challenge. The buy-back by “open market through stock exchange” method results in double taxation in the hands of the company by way of BBT and shareholders as capital gains or business income. In stock exchange transactions, the selling shareholders are not aware if the company is the buyer, and the company has no knowledge of the identity of the seller. Such open market buy-back should be exempted from BBT to avoid double taxation. Consequentially, these transactions should continue to be subject to capital gains/business income tax in the hands of shareholders.

Currently, the carried forward short-term capital loss can be set off both against LTCG and STCG. However, the carried forward long-term capital loss can be set off only against LTCG considering that the tax rate of LTCG (20 per cent) is lower than that of STCG (30 per cent). Since the STCG tax (15 per cent) on listed equity shares, equity-oriented mutual funds and REIT/Invit units is lower than the LTCG tax (20 per cent), the taxpayers should be allowed to set off long-term capital loss against STCG.

India’s growth story and strong fundamentals have attracted both foreign and domestic investors.

The next level of reforms will be critical to enhancing India’s position in the global economy. Tax reforms will play a significant role in this journey and, consequently, a reformed capital gains tax regime would be highly appreciated.

The writer is national tax Leader, EY India. Views expressed are personal