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Simplify capital gains tax regime
January, 28th 2008
The origin of capital gains tax in India dates back to 1956, following the recommendations of Prof Kaldor to levy tax on profits arising on sale/transfer of specified non-inventory asset.
As a result of constant evolution, capital gains tax, as it stands today, is levied on sale of all capital assets (other than held as stock-in-trade) with a computation mechanism prescribed under the Act.
Over the past two decades, several exemptions were incorporated in the statute to rationalise the levy with a view to mitigate undue hardship to taxpayers. In the past few years, the levy (or non-levy) of capital gains tax on profits arising on sale of capital market instruments (shares, units, etc) has emerged as an effective tool to foster the growth of capital market. 
In the Finance Act of 2003, the then Finance minister introduced an exemption from capital gains on sale of securities forming part of BSE 500 index. Later, as the capital market exuded resilience in view of the growth in transaction and confidence of institutional and retail investors, exemption was extended for all listed securities, of course subject to levy of minimal Securities Transaction Tax. 
The policy makers intent underlying complete tax exemption being extended to gains on capital market instruments has been to create and sustain a conducive environment for growth of the domestic capital market.
These complexities are increasingly becoming stark in todays context when the macro-economic fundamentals are seeing a paradigm shift with appreciating the rupee, unabated capital inflows and bulging forex reserve. Further, an investors objective, which in the past was driven by annual dividend yields, has now shifted to capital appreciation, based on future earnings.
The debate over whether gain arising on sale of securities are to be treated as business income or capital gains has now been long drawn. 
Following the (conflicting) rulings of Advance Ruling Authority in Fidelitys case, the CBDT, in June 2007, issued a circular clarifying the distinction between stock-in-trade and investment. The circular did not break any fresh ground in as much as it only reaffirms the principles enunciated by the Supreme Court in its decisions pronounced in the seventies. 
Admittedly, the decision of the Apex court can not be questioned, however, the moot question is whether the principles pronounced over three decades back would still hold good The vexed issue begs for certainty and answer by way of legislative change, not just for individuals, but also for institutional investors.
Another aspect which highlights the inherent complexity and bias is the manner in which taxable capital gains are computed for non-resident tax payers.  Non-residents are required to compute the taxable capital gain in the same currency in which shares were acquired by using the prevailing exchange rates. In addition, a non-resident is not eligible for benefit of indexation on the cost of acquisition of securities purchased in foreign currency.
Computation of capital gains tax liability in foreign currency surely would have made economic sense when the foreign currency was appreciating vis--vis the rupee; I am not convinced if this mechanism still makes sense given the movement of the US dollar for the past few years with no imminent economic indication that it would retrieve the lost ground in the foreseeable future.
Another aspect that has intrigued me is the debate on applicability of tax rate to non-residents in respect of long term capital gains arising on sale of listed securities.  In recent judicial decisions, non-resident tax payers were denied the beneficial tax rate of 10 per cent on long-term gains arising on securities. 
Though, the AAR ruling in Timkens case has reaffirmed the intent of legislature by allowing the beneficial tax rate, it's time that this anomaly, which may lead to unjust inequality to non-resident taxpayers, be put to rest by a suitable amendment. 
Lastly, the current regime provides exemption from capital gains on sale of securities transacted on a recognised stock exchange. Any gains arising on private placement deals and transfer of shares by promoter groups are not eligible for exemption from capital gains. I am forced to ponder: Is there any economic rationale, or it is that this move is only biding its time.
There is case to simplify the provisions on capital gains exemption. No surprise, this ranks high on my wish-list for the Union Budget of 2008!
Mukesh Butani
The author is partner, BMR & Associates. Views expressed are personal
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