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How new LTCG tax with STT violates three basic principles of taxation
February, 12th 2018

The conversations around the proposed long term capital gains (LTCG) tax refuse to die. As one reads the explanations and arguments, it becomes increasingly clear that we need a set of core principles to fall back on. Else we will keep running around in circles.

There is merit in the argument that capital gains, both long and short-term should be taxed. The problem is in how we have chosen to implement this idea.

There is no denying that when income is generated, it should be subjected to tax. The more exemptions there are, the greater are revenue loss and inequities. Special treatment to income and assets are also inequitable to the tax paying citizens. Exempting capital assets from being taxed is thus not a defensible idea in itself.

Arguments that capital gains are earned by money that lies idle, or that there is a large gain and giving a small portion of it won't hurt, smack of poor understanding of capital markets, and an intent to usurp what might have been rightfully earned. They are thus wrong in principle. In taxing income, the recognition of subsequent earning capability of money that has been taxed already is an established principle. That is why rent and interest from property and bonds are taxable, even if bought using post-tax income.

Capital gain is an income that accrues in the books of the investor when the capital asset is sold. In taxing this income, there are three principles to consider: First, there can be gains or losses when an asset is sold. If gains are subject to tax, losses are eligible for set off. Second, the gain is the difference between the sale price and cost, and a reasonable computation of cost has to be arrived at. Third, not all gains may represent income. An asset may appreciate in value merely due to increase in overall cost of goods, or inflation.

The Budget proposal fails to apply these principles to long term capital gains from equity, which leaves it open for argument, compromise and modification in the future. That is a problem. Around every Budget season in future, reasonable arguments asking for set off, currency conversation costs and indexation will be made.

We will now turn to the rate of tax.Keeping it simple is a great idea. There is little merit in introducing new rates and modifying them often. A flat rate of tax is also punitive as it fails to honour the primary principle of progressively taxing higher income at higher rates. Determining sources of income and taxing them at the marginal rate applicable to an entity is a simple and equitable principle. This ensures that a tax-exempt investor who earns capital gains is not subject to tax depending on source of income, but stays at the slab that applies to his overall income.

However, the government uses tax rates to direct investments and provide incentives. Exempting capital gains, taxing short-term capital gains at 15% instead of the marginal rate, are all specific incentives to encourage equity investments. There is data to show an enhanced level of activity in equity markets since these steps were introduced, but negligible increase in per engage of the population using equity investing as a choice. It is also tough to separate the impact of technology from tax on the growing volume of equity transactions.

Why 10%? Because long-term tax rate had to be lower than short term rate of 15%. Why the `1 lakh exemption? So the flat rate does not hurt the marginal earners of capital gains. The problem with these proposals is that they incrementally modify what is there. They will thus come up for revisions and modifications as arguments are made about their inequity.

Why not tax capital gain at marginal rates, allowing set off and indexation benefits to long-term gains? The worry is compliance. Capital gains are realised on the books of the investor to which the taxman has no access, unless there is a scrutiny. Many readers pointed out that brokers provide all details. But that is a service to the investor, not monitored by tax authorities, unlike say the TDS is mapped with PAN.

The task of linking each sale to its cost, and determining the gains using first-infirst-out principles is the job of the accountant. Not all investors are subject to tax audit requirements. The onus of reporting gains correctly and paying taxes on them is on the investor. Given the scant regard for rule of law, evidenced by rampant evasion of taxes, it is unrealistic to expect honest payment of all taxes on capital gains as earned. Worse, it is onerous to fix evasion given the scale of transactions.

Therefore, taxing capital gains at a lower rate was intended as an incentive for compliance. The proposed 10% tax also intends to encourage compliance by pointing out how small it really is compared to the gains made on equity. An argument that has been put forth a lot, but won't do much with respect to actual compliance, except from a minority that cares for integrity in reporting income and paying taxes.


Then there are questions of inequity and unfair treatment. Why should insurance proceeds that include capital gains from equity be exempt? Why should long-term for equity be one year? Why should transactions in an IFC be exempt? These are all exemptions that stem from apprehension about disturbing status quo, or patronising pet projects. They are not tenable positions.


There is nothing equitable about STT. It is a flat levy and is collected with no regard to income tax slab or status of the payer. Even a tax exempt mutual funds pays it.

Its merit is the ease of collection and compliance. A few large business entities are responsible for implementation and it is easy to audit and hold them accountable. Levying STT enabled bringing short term capital gains tax rate from marginal rates to 15% and exempting long term gains. To keep STT and impose a new tax is just the Finance Minister trying his luck with a few more rupees of tax collection.


The problem is the proposal patches on to what is there with ad hoc assumptions. It tries to get away by pointing out that 10% is too small to crib about.

 

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