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A fair tax for long-term capital gains
December, 28th 2016

As we head into the budget season, two standout features of India’s federal tax system need to be reiterated. Firstly, the tax to gross domestic product (GDP) ratio is very low. Last year’s Economic Survey says that at 16.6%, India’s ratio is lower than the emerging market economy average of 21%. It is also much lower than the Organization for Economic Co-operation and Development (OECD) average of 34%. Granted that income from agriculture is exempt from taxation in India. Even then the ratio of tax to taxable GDP ratio is still quite low. Among G-20 countries, India’s ratio is the third lowest, only slightly ahead of Mexico and Indonesia. Even when compared to countries with similar per-capita income (measured by purchasing power adjusted per capita GDP), India falls woefully short.

Instead of overall tax collection, if we look at only the direct tax to GDP ratio, India is nearly at the bottom. The Economic Survey last year did a splendid job of rigorously analysing this phenomenon, and the conclusion is inescapable. That India under-taxes its people, and hence under-spends, especially on social sectors like health and education.

The second standout feature of our tax system is the skew between direct and indirect taxes. If you count all the indirect taxes paid at the national, state and local level, the ratio of direct to indirect taxes is 1 to 3. This is astonishingly skewed, since for most developed nations it is exactly the opposite. In 1993, when the Raja Chelliah committee on tax reforms submitted its report, the break-up of total taxes was 85% from indirect and only 15% from direct taxes. Over the past two decades, this skew has corrected only slightly. Needless to say, indirect taxes impinge disproportionately more on the poor and are inherently unfair.

If we want our tax system to be more equitable and fair, we need to sharply correct skew in favour of more direct taxes. The soon to be rolled out goods and services tax (GST) will replace existing indirect taxes like excise and value-added tax, but will nevertheless be an indirect tax. This is being hailed as a revolutionary tax reform and will undoubtedly go a long way in reducing leakage, increasing compliance, reducing inefficient cascading taxes and, also, boosting economic growth. What it will not do is reduce the skewed influence of indirect taxation.

India’s approach to direct taxes has been less than enthusiastic. Presumably this effort was thwarted earlier by inadequate technology preparedness, and the fact that only 10% of the workforce is subject to presumptive tax on salaries. Tax on wealth and inheritance is very nominal, if at all. When it comes to tax on capital gains, made in the securities markets, India’s approach has been very liberal. Ever since 2004-5, long-term capital gains (LTCG) have been tax-free, and short-term capital gains (made in less than one year) are subject to a rate of 15%. The liberal treatment of LTCG was considered necessary to treat domestic stock market investors treatment on par with investors coming in from Mauritius. The tax treaty with Mauritius, signed in 1983, has cast a long shadow on India’s domestic tax agenda. As recently as this year, there were demands that the capital gains tax exemption be extended from listed stocks to unlisted stocks, and to other asset classes like real estate trusts. The treaty is also infamous for high-profile tax disputes.

This past summer, the Narendra Modi government finally cut the Gordian knot by amending the tax treaty. This was a relatively unsung but revolutionary tax reform. Opponents had warned that there would be hell to pay as foreign investors would flee India if deprived of the freebie Mauritius route. Nothing of that sort happened, and the amended Mauritius pact will serve as a template for other countries as well.

The amount of tax foregone because of tax-free LTCG can be gauged from data released by the tax authorities this year. In assessment year 2014-15, the total amount that escaped the tax net due to LTCG was Rs64,521 crore. A recent research report published in the Economic And Political Weekly estimates the loss to the exchequer due to capital gains tax exemption at Rs45,000 crore. Just by way of comparison, in the US, all short-term gains are taxed as regular business income, and long-term gains are taxed at a rate of 15%.

It must also be remembered that most foreign investors (FII) who come into India are long-only funds, with a minimum time horizon of three years. So for these investors, gains made in one year are immaterial. Hence it is inconsequential to them if gains beyond one year are made tax-exempt. It, of course, matters a lot for the exchequer. So, ideally, the LTCG tax exemption should kick in after completing three years. Anything shorter, the capital gains should be like regular income. Such a non-discriminatory and transparent tax regime will do away with arbitrage between gains in listed versus unlisted stocks and also foreign versus domestic investors. Such simple, non-discriminatory and transparent tax rules will spur, not deter, capital raising in the securities markets.

It is in this context that one must appreciate Prime Minister Modi’s recent remarks on taxing gains from securities markets.

Since 1991, the economy has quadrupled in real terms, but stock market wealth as measured by the index has increased by more than 15 times. The contribution to the treasury has been less than commensurate. Correcting the direct-indirect tax skew also would mean bringing the long-term capital gains tax at par with our peer countries.

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