The tax regime is complicated for financial traders though the final tax rates are moderate. Transactions attract securities transaction tax (STT), as well as service taxes, stamp duties, etc. Equity dividends are not taxed in the hands of the receiver. The logic is that this would be double-taxation since a company pays taxes on its profits before distributing dividends.
Long-term capital gains on securities held for over a year are also tax-exempt. Profits booked within a year from trading are taxed as short-term capital gains. Profits and losses can be offset against each other, but not against other income.
The structure leaves several routes open for legal tax avoidance. A smart investor can generate a large tax-free dividend income. The offsets of profits versus losses can also be used cleverly to avoid taxes by dividend-stripping.
At the right moment, the investor buys into a stock expected to pay a large dividend. Once the dividend is paid, the stock price falls, and he sells. A tax-free dividend is received and also a tax break since the notional capital loss offset genuine profits. The tax revenue accruing from capital gains on listed securities transactions is about Rs 3,000 crore per annum. This is very low, given that the transaction volumes regularly exceed Rs 150,000 crore per day. STT revenues are more than twice as high, running at over Rs 7,500 crore per year.
The fact that STT is a more reliable route to revenue helps to explain the Shome Committee recommendations that a hike in the STT rate be coupled to the elimination of taxes on short-term capital gains. This would also equalise the tax rates between Indians and FIIs, who avoid paying capital gains tax by being headquartered in overseas tax-havens.
If traders behave rationally, such a change may lead to a temporary fall in trading volumes. Somebody who does pay short-term capital gains tax will gain from the proposed changes. But few traders actually make serious profits. In fact, most traders make losses.
The bulk of traders transact multiple times in every session. The frequent trading segment exhibits behaviour in line with the famous pareto principle: I'd guess that 10 per cent of frequent traders make 90 per cent of the short-term trading profits. The tax authorities should know the exact levels, if they bother to mine the data.
If traders behave rationally, they will cut back on their frequency of trading and thereby impact volumes. But while this may happen in the short run, history suggests that it won't happen, at least not in the long run.
When STT was introduced, the response was initially negative, But traders eventually absorbed the extra costs and volumes normalised. The Shome Committee is presumably hoping that the pattern would be similar if STT rates are hiked. It helped that the STT was introduced in fiscal 2004-05 early into a four-year bull market. The market situation is not so favourable now. But it will improve sooner or later and n the long run, most frequent traders will absorb the extra costs. If the Shome Committee recommendations are implemented, it might have another, more subtle effect. A hike in STT coupled to the removal of short-term capital gains tax should induce the smarter day-traders to change their methods and preferred timeframes.
Any trade that is closed out in less than one year gains in tax efficiency. The potential profitability increases by almost 30 per cent. A medium-term positional trade, lasting more than one session but less than one year, becomes much more attractive.
Such a timeframe requires a higher capital base than intra-day trading. Any medium-term position may run at a loss for multiple sessions. But the potential rewards are also much higher than in day-trading. This segment of the market has a more even distribution of profits. That's probably because the medium-term trader is much more sophisticated.
Apart from requiring more capital, trading for the medium-term requires a different mental attitude and a wider set of skills. For one thing, it requires more patience. It also requires a more careful juggling of stop losses and a better understanding of leverage. The trader also has to develop an ability to identify lasting trends – whether through fundamental means, or purely technically or a combination of both. This requires quite a lot of work and it usually involves taking quite a few painful losses.
While there's no certainty about the adoption of the Shome recommendations, the Finance Minister likes STT, and he was responsible for its debut. It cannot hurt for traders to get prepared for changes on the lines outlined above.
