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Tax exemptions for short-term stock market profits undermines fairness of tax policy
November, 20th 2012

Indian tax policy belongs to the theatre of the absurd. In 2009, for a new tax code, the Direct Taxes Code ( DTC), policymakers wanted to tax all forms of capital gains at maximum marginal rate, scrap securities transaction tax (STT) and reintroduce taxation on long-term gains from listed equities.

And within three years, taxation proposals couldn't be more different: increase STT and abolish all forms of taxation - business income tax, short-term capital gains tax and long-term capital gains tax - on stock market profits. In one stroke, stock markets will be equated to the holy cow of Indian tax law: agriculture. The Dr Shome Committee has mostly done a sterling job but tax exemptions for short-term stock market profits undermines fairness of tax policy.

Earlier this year, Indian policymakers hit rock bottom with poorly-drafted proposals to introduce general anti-avoidance rules (Gaar) and retrospective taxation. However, once foreign capital evaporated and the rupee dived, the political leadership demonstrated courage in acknowledging policy errors and quickly changing course. The appointment of the Shome panel with a roving mandate on Gaar, retrospective taxation and other issues of non-resident taxation was a masterstroke.

The Shome panel report is the first time Indian policymakers have acknowledged that tax policy is an instrument in the competition for global capital. In order to understand the nature of competition, one needs to appreciate two key factors:

Most investment destinations offer a tax-exempt route, directly or through offshore financial centres (OFCs) such as Cayman or Mauritius, which enables global funds to invest in their stock markets; and

Most global funds are domiciled in OFCs and anchored by tax-exempt investors, such as pension plans and university endowments.

In this milieu, the India-Mauritius tax treaty served India well by offering a tax-exempt investment route for global funds investing in India. Recognising market realities, the Shome panel has sensibly recommended that India must (a) defer Gaar, and (b) not use Gaar to overrule limitation of benefits (LoB) clauses in double tax treaties.

The Shome panel has also recommended that, for now, India must continue to accept a Tax Residency Certificate (TRC) issued by Mauritius as per CBDT Circular 789 while assessing tax filings of Mauritius residents who claim benefits of the India-Mauritius double tax treaty. So far so good. And then, the committee goes astray with its recommendation that India should withdraw Circular 789 after exempting short-term stock market profits from all forms of taxation!

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