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View: Benefits of zero tax on LTCG outweigh the possible revenue loss to the exchequer

By Vikram S Mehta

Capital markets serve a vital function of..

By Vikram S Mehta

Capital markets serve a vital function of transferring resources from savers to users of capital, thereby facilitating capital formation. In a capital-starved country like India, over 60 per cent of savings have historically gone into unproductive asset classes like gold and real estate. In developed economies, a bulk of savings go into financial assets.

Artificially high real estate prices have increased an important factor cost, making industry and services less competitive, and housing unaffordable for genuine users. Financial assets present a flexible, liquid and easy-to-operate investment option. They are catalysts for growth in production, services, employment and tax revenue.

So, it was important to correct this imbalance and channelise savings to financial assets. Taxes of gains on listed equities where the period of holding is greater than one year, long-term capital gains (LTCG), was made zero.

A Securities Transaction Tax (STT) was imposed to partly compensate the exchequer for the loss in revenue. Taxation on certain other financial instruments was also moderated.

Last year, Prime Minister Narendra Modi stated that the capital markets should contribute their share to 'nation-building'. The case for the reposition of LTCG has come up again in the run-up to Budget 2018. The Bombay Stock Exchange's (BSE) recent argument to the finance ministry to reimpose the LTCG tax on long-term listed equities was solely based on the potential revenue loss to the exchequer owing to abuse of this provision. But such abuse is committed by less than 2 per cent of the investor population.

Defunct or non-operational companies lie at the root of the problem. They are characterised by low trading volumes and present ideal platforms for operators to do circular trading to convert black money into white.

BSE may consider mandatorily delisting such companies, after providing for minority protection. Heightened surveillance and monitoring by the exchanges and Sebi of listed shell companies, along with timely action against errant brokers, will minimise misuse.

An argument is made as to why listed equities should get preferential taxation treatment vis-a-vis other asset classes. Corporate income is subject to multiple levels of taxation before it reaches the shareholder: corporate income tax, dividend distribution tax (payable by the company) and tax on dividend, if the dividend income exceeds Rs 10 lakh, in the hands of the recipient. This cascading taxation, coupled with STT, more than justifies the zero rate on LTCG.

Equities should be viewed as a long-term wealth-creating asset class. Hence, the period of holding of one year, to qualify for no taxation, motivates investor behaviour in that direction. Healthy capital markets facilitate the exit of venture capitalists and private funds who had invested in companies that were micro, small and medium enterprises (MSMEs) and have now matured. Policy should facilitate the flow of capital to MSMEs, which form over 60 per cent jobs, by providing investors with a liquidity event.

GoI should plan to raise disinvestment targets and reduce dependence on taxes not only for fiscal stability but also for increasing the efficiency of utilisation of its own capital.

Even non-strategic divestment has led to better performance of PSU managers as they are put under the spotlight. A string of quality IPOs, strong inflows into the equity markets post-demonetisation, recovery in corporate earnings, better corporate governance measures instituted by Sebi and new structural reform measures, have all helped in developing a much-needed equity cult. This momentum needs to be sustained to support further divestments.

The urban middle class faces inflation higher than what is thrown up by statistics. Hence, a hedge is needed to offset this. Despite demonetisation and GST, Indian equities have performed remarkably well over the last year. For the first time in years, domestic fund flows have countered foreign fund flows. The strength of the US economy and the tax cuts will attract capital back to the US. So, it is important to maintain status quo to avoid any sudden fund outflows.

Uday Kotak recently observed that it has been FIIs that have mainly benefited from HDFC's consistent growth in market capitalisation. The much-needed parity in taxation of the Indian investor vis-a-vis the foreign investor brought about by the amendment to the Mauritius tax treaty should not be disturbed, and round-tripping should not again be encouraged.

It is time India's future is built on domestic sources of capital, and Indians benefit from the country's golden years of growth. The benefits of a zero tax on LTCG to the broader socio-economic system far outweigh the possible revenue loss to the exchequer.

(The writer is partner, S S Kothari Mehta & Co)

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