Should turnover tax replace capital gains tax?

DEBATE/ The move may reduce paperwork, but transactions costs will increase substantially

S A Narayan, MD, Kotak Securities &
Nimish Shah, CEO, Parag Parikh

S A Narayan
Managing Director,
Kotak Securities

The key to effective policy-making is to work backwards from the goalpost "" keeping in sync with the current football fever "" with sharp focus and clarity of purpose.

There have been media reports that the government is thinking of replacing the long-term and short-term capital gains with a turnover tax on the transactions in the equity market, that, too, at a fairly high rate of 0.1 per cent of transaction value.

The question is whether such a step will yield the desired result. Or would it be detrimental to the equity market as a whole? Will the turnover tax improve market efficiencies? And will tax revenues from turnover tax be higher? There is no doubt about the complexities involved in capital gains taxation calculations, but does this merit a move to abolish the tax?

The futures and options (F&O) segment of the equities markets eliminates the inefficiencies of the price discovery mechanism from the system and provides a healthy opportunity for arbitrageurs and hedgers.

Today, the F&O segment constitutes nearly 50 per cent of the average daily turnover and, sometimes, up to 200 per cent of the cash market transactions. The other 50 per cent of turnover is from the cash segment, within which only 25 per cent is settled by delivery of shares. This is in line with the more mature international markets and it is expected that the share of F&O will increase further.

In rupee terms, out of the total daily turnover of approximately Rs 120 billion, Rs 15 billion ends up in delivery-based transactions and the remaining Rs 105 billion is squared off or settled by payment or receipt of differences of values. In a bull run, these numbers normally double.

Day traders and arbitrageurs are the key players in the cash and forward segments, respectively. Day traders operate on wafer-thin margins, churning their portfolios on small price movements. These players provide liquidity and enable price discovery.

In the F&O segment, the non-delivery-based transactions are done on small margins. The arbitrageurs normally earn less than 1 per cent a month, that too after churning the portfolio many times. These players are able to do their trades mainly because the transaction cost is low. Any increase in transaction costs would make the proposition economically unviable.

Besides, foreign institutional investors (FIIs) and local players also hedge their cash positions through counter positions in the F&O segment, which means there are four transactions for every exposure. With a turnover tax of 0.1 per cent, transactions costs would go up by an additional 4.8 per cent a year, exceptionally high by any standards.

Thus, the imposition of a turnover tax on non-delivery-based transactions will adversely impact market efficiencies. This impact was witnessed earlier when the Securities and Exchange Board of India (Sebi) imposed a turnover-based fee on market participants at the rate of 0.01 per cent for delivery-based and 0.001 per cent for non-delivery-based transactions.

An additional 0.1 per cent, that is, 10 times more than existing ones for delivery-based and 100 times for non-delivery-based transactions, would take away all the benefits of doing such transactions.

On the one hand, a turnover tax as against capital gains could imply lower tax incidence, less taxation complexities and increased tax revenues.

On the other hand, there would be a substantial drop in liquidity leading to an increase in impact costs, in turn, reducing the participation of larger players such as FIIs. This would defeat the basic purpose of imposing the tax because lower participation means lower revenue.

However, FIIs want clarity on tax treatments so that there are no tax issues later. In today's situation, especially for Mauritius-based FIIs, there is a lurking fear of the taxman knocking on the door. This, besides creating uncertainty in the minds of the FIIs, also affects the market adversely. Thus, FIIs may be happy with a turnover tax vis-à-vis a capital gains and this may, in fact, encourage more FIIs to get registered.

In conclusion, a viable solution to this debate over turnover tax versus capital gains is the imposition of a turnover tax only for FIIs. But tax rates must be reasonable and the rate for F&O trades should be substantially lower. This will create a level playing field and also avoid policy-related uncertainty on various tax issues.

The need of the hour, however, is clarity and simplicity of taxation. This would definitely be an added incentive for FIIs waiting in the wings to invest in the Indian market.

Nimish Shah
Director and CEO,
Parag Parikh Financial Advisory Services Ltd

The capital markets are expecting a change in the way it pays taxes on investments in the forthcoming Union Budget to be announced by Finance Minister P Chidambaram this week. Capital gains tax has served the country for many years now. There are a couple of alternative ideas floating that include having a single-rate capital gains tax to replace the dual-rate short- and long-term capital gains tax.

Turnover tax, another alternative, is a far superior system. It is simple, transparent and dramatically reduces paperwork "" both for the taxpayer and the taxman.

This system changes the entire perspective on buying and selling shares. The government is not concerned about the profits or losses an investor makes: it gets its share from the transaction done by the investor.

Investors can be divided into speculators and long-term investors. Speculative turnover forms a major chunk of the stock market turnover. Speculative traders, like others, will be at a disadvantage since they would have to pay tax even on a transaction that results in a loss. The business design of speculators is short-term-oriented, they square up the huge positions in a small differential.

It's a high-volume, low-margin game where costs matter the most. But there would also then be no subsequent taxes on trading profits. There would be a tremendous redu-ction in paperwork. Filing of returns would be much simpler.

Chartered accountants of speculative investors should also heave a sigh of relief because brokers would charge the turnover tax and pay the government. They would not have to prove every transaction and its resultant profit or loss. The taxman currently views an investor and a trader differently. Just for a few transactions, many investors are treated as traders and the profits are taxed as business income and not as capital gains.

Turnover tax will also help create a level playing field among various capital market players. It will create parity among foreign and local investors and annul the advantage of investing through offshore companies. It will also stop the tax-avoidance strategies of "buying" losses to offset profits.

Dividend stripping and double index-ation benefits, too, would disappear. Dividend stripping comes with the rider of three months' investment horizon to take advantage of the short-term capital losses. But many investors who have taken advantage of dividend stripping have had to face the wrath of the taxman. They have to prove that the investment was not done solely to avoid taxes.

It is important to note that Indian stock markets are shallow and illiquid. The majority of the volume is in the top 100 securities and most of it is speculative volume. Day traders and brokers who encourage speculation would be the ones who could resent such a move because they would be the worst hit. Brokers who have a business design that caters predominantly to speculative clients charge only 0.1 per cent as brokerage. And a 0.1 per cent turnover tax will double the cost of trading.

The government has to ensure a reasonable turnover tax rate so as not to hamper trading volumes.Long-term investors and brokerage houses that have a business design that enco-urages long-term value or growth-based stocks will benefit. Such strategies dis-courage frequent churning of portfolios. Thus, the cost to such investors would be minimal and they would more than welcome turnover tax.

To sum up, turnover tax in the right proportion would be a great benefit to the capital markets. Being simple and easy to implement, it would encourage rather than dis-courage volumes. I am sure investors won't have much to complain about.