We have had all kinds of experts analyse the direct tax code; tax consultants, tax lawyers, corporate counsels, CFOs. Indias best known investor and Dalal Street guru Rakesh Jhunjhunwala and Mukesh Butani of BMR analyse the direct tax code and its proposed changes to the capital gains tax regime.

The direct tax code does propose a paradigm shift in the taxation of capital gains. It says all capital gains to be taxed as income and it does away with Securities Transactions Tax (STT). So, how is this going down with the investor community? Well-known investor Rakesh Jhunjhunwala and tax expert Mukesh Butani, Partner of BMR Advisors discuss.  
Here is a verbatim transcript of an exclusive interview with Rakesh Jhunjhunwala and Mukesh Butani on CNBC-TV18. Also watch the accompanying video.

Q: What do you make of the proposed changes in the direct tax code when it comes to the taxation of capital gains; the fact that there would be no distinction any longer between long-term and short-term, the fact that we at 0% long-term will now go away and that all capital gains will be taxed as regular income. How much is that going to hurt investors sentiment? Do you think its going to make a big dent?

Jhunjhunwala: First all its a misconceived concept that today there is no capital gains tax. There is a capital gains tax in the form of Securities Transactions Tax (STT). So, the question is, I agree with the basic approach and the equation of the direct tax code that lesser exemptions, lesser rate of tax. But the real debate is, there should be shift from STT towards the regime of capital gains and if I were to decide there are two exchanges who pay 99% of the STT and it comes every month within seven days, government needs no administrative machinery to implement it and as time passes volumes are just going to go through the roof and the STT is going to go through the roof. Second thing I feel that this country really needs risk capital and worldwide risk capital always gets concessions; its not unique to India and in this proposed direct tax code there is no capital gains, there is only income.

So, what is a difference between debt investing and equity investing or any capital investing? So, in a state in which the country needs large capital investments needs risk capital. You want to take away all the benefits, I think we should continue the STT and we should have the short-term capital gains at whatever rate is there and the long-term capital gains fully tax-free.

Q: If this code were to become law as is, what do you think is likely to happen on April 1, 2011 or just the day before that. Do you think that investor sentiment will turn dramatically or are we all being exaggerated in our forecast?

Jhunjhunwala: I surely know one thing that if the tax code is introduced in the form in which it is then between January 1, 2011 and March 31, 2011 there is going to be a slaughter in the markets. If I hold equity, if I sell on April 1, I am taxed and if I sell on March 31, I am not taxed. So, obviously I would like to book my gains without being taxed. This is also question we have to point out.

Q: How do they do it across the world? I mean most countries do apply or levy some kind of capital gains tax, so is our tax department so wrong, wanting to bring back some measure of taxation on capital gains most of which in that sense enjoying a 0% tax when it came to long-term gains and also let me ask you the question that Rakesh brought up that STT was a great tax; it was easy to administer, impossible to wade almost. So, why are they doing away with that. Are they likely to collect a lot more money in the way that they are trying to impose capital gains tax in this code and is the revenue consideration, the only consideration in this?

Butani: I dont think revenue consideration is the only consideration. They will probably collect more securities transaction tax if the volumes increase. I think there are three phases in which the capital gains tax regime as it is evolved today.

In 1992 when the government announced the foreign institutional investor (FII) policy immediately thereafter in the 93 budget Dr. Manmohan Singh said that FIIs are an important source of investment in our country and we should tax them in a concessional manner and thereafter the Bhartiya Janta Party (BJP) government brought about a change which said that long-term capital gains should not be taxed and then came the last set of reform by Mr. Chidambaram when he said that rather than going through this complex system of collecting taxes, lets collect Securities Transactions Tax because you tax it in a simplified manner and as Mr. Jhunjhunwala said, the whole collection machinery is so simplified that the tax administrator have to pay for nothing to collect those taxes. I think in the garb of simplifying the taxes we have complicated it. We are now talking about a very complex set of distinction between what is an investment asset, what is a business asset.

The business asset has again two categories. I think this whole concept is not going to work in my view; its going to cause enormous amount of confusion because as it is, it is very difficult to classify whether a particular asset is a business asset or as an investment asset.

Q: As the code proposes it, everything gets clubbed and everything gets taxed at your income tax rate? Is that correct?

Butani: Exactly. So, this classification in my view is irrelevant because everything is taxed at 30%, so there is no difference between a long-term investor and a short-term investor. As far as your question on what other countries do there are many counties that dont even tax capital gains, Singapore is a classic example it doesnt tax capital gains.

So, I think this provision is regressive in my view and if I may have to give you another example - moving away from investor like Mr. Jhunjhunwala lets take two categories of investors and Mr. Jhunjhunwala perhaps is in the middle of those investors. Here the foreign institutional investors just in the calendar year 2009 until September 15, you had USD 8.6 billion invested. In a situation where the entire global economies are going through recession and they have invested because they see the potential in the Indian market for a rate of return.

There is a growing perception amongst FIIs that too many regulatory changes in India is causing anxiety to them and I wonder what would be going on the minds of 1,000 odd FIIs that are registered with the Securities and Exchange Board of India (SEBI). Take another category of investors on other side, individuals; we as it is have a challenge that there are several middleclass people who do not form a part of the stock market growth and capital appreciation story. For them it is certainly an incentive to come and invest in a capital market that taxes you in a moderate manner.

Q: You have also raised what is very ironical; let me guess but most FIIs come through either the Mauritius or Singapore route or some such route. So, in effect they are unlikely to have to pay any tax under a new capital gains tax regime. If this code does become law the guys who will get penalised under this new regime or who will come under this new regime so to speak and will be the big tax payers will be the domestic investors?

Butani: Not necessarily because this 30% rate of tax coupled with the general anti-avoidance rules means that the government would like to overwrite the treaty and make the FIIs also pay tax at 30%.

Q: You were telling me that you thought that it was extremely unfair that many foreign institutional investors will probably not have to pay tax because they come in from lower tax regimes like Mauritius but its the domestic investor that will get hurt?

Jhunjhunwala: To put an end to all those arguments, the STT is a very equitable and accepted tax because there whether you are FII, whether you are a small investor, whether you are a big investor everybody is paying taxes.

Q: No matter what you and I think of STT, the fact is that the government seems to want to do away with it and bring longer-term capital gains under the tax net?

Jhunjhunwala: We know what the government wants to do. They have solicited the opinion of the people of India. So, we are discussing what our opinion is and I dont think Government of India has pre decided. The Central Board of Direct Taxes (CBDT) has setup a panel to examine the direct tax code. Its going to go through a parliamentary committee. So, I dont think whatever the direct tax code has been proposed as it is, is the holy bible. 

Q: What you are saying is as it is proposed now; it is unacceptable to investors or definitely undesirable. Are you also saying that they should stick with their policy of having no tax on long-term capital gains or is there some measured way that they can bring in tax on long-term capital gains but not in this fashion? Is there any other suggestion that you have?

Jhunjhunwala: You have the STT, your short-term capital gains at 15% which is 50% of the normal tax rate and if you feel too much long-term is escaping taxation instead of 12; you make it 18-24 months. Sometimes the STT maybe lower than the possible capital gains but for risk capital you need some concession.

Q: While we are discussing things that you dont like about this code, you also indicated to me that you are not terribly kicked or excited about this whole decision or proposal to impose wealth tax either?

Jhunjhunwala: I dont want to go back to the days of socialism. I dont want to be penalised for creating and earning wealth. Why should I be penalised. So, what I will do, I will say, my wealth is now Rs 45 crore let me not create anything more because I will come into the wealth tax. Why in the world you want to penalise somebody to create wealth.

Q: Can it really be a disincentive to create wealth, a higher tax regime?

Jhunjhunwala: It is a disincentive. Its not a question of 0.25%; why should I pay 0.1%. Dont penalise the creator, penalise the inheritor.

Q: So have an estate tax and not a wealth tax in fact many parts of the world, many leading investors in most of the worlds biggest billionaires believe that estate tax is more efficient in that sense or a more equitable than wealth tax. Where do you stand in all of this?

Butani: Wealth tax is another example, for many years till the mid 90s we had an extremely complex wealth tax legislation and when the law was amended, they said we are going to levy tax only on non-productive assets like land or the jewellery and the reason to amend the law was that the cost of administering the wealth tax law was higher than the cost of wealth tax that the government collected. Now we are again back to the same regime. We have taken away this whole classification of productive and non-productive assets and we have said we are going to tax the entire asset. I think that this is a regressive step. As far as your question on estate duty or inheritance tax is concerned I think most economies have inheritance tax and I was surprised that in the direct tax code there was no mention of inheritance tax. So, I dont know whether the government did not have time to draft the inheritance tax law and this is an interim arrangement but it certainly make sense to have an inheritance tax at moderate rates rather than making a person pay wealth tax on a year on year basis though I am sure very few people in our country will get impacted and you can see Mr. Jhunjhunwala because he would be one of the wealth tax payers in the country and you can see his reaction.

Q: You have the ear of the tax department; I am sure all this feedback has been going back to them for the last one month or so. Do you sense any agreement in maybe wanting to review or rethink this whole capital gains tax situation?

Butani: I think there are few aspects; one is that there are simple drafting errors in the law and as people are reading the law those drafting errors are getting picked up. I havent seen anything coming by way of reaction from the government whether they are going to look at it or renew it. But at the end of the day this is a working paper, it is going to go through a debate, it is probably going to go through a much more lengthy debate than what I had thought it to be and I have no doubt in my mind. As a matter of fact I am confident that the final direct tax code which will become the letter of the law will look materially different than what the direct tax code looks in a draft form today.

Q: You mentioned Singapore as having no capital gains tax. We know Mauritius is also a far easier regime. But what about developed countries like the US or UK, whats their capital gains tax regime?

Butani: The capital gains tax rates are moderate and the rates of tax are lower than how you tax an income and the reason in the rational for that is very simple. Your income represents excess of profits that you earn out of a business from the day to day operations. Your capital assets and the gains that you derive out of those capital assets result in an accretion, as a result of the risk that you have undertaken to make that investment and it is always taxed at a rate lesser than the normal rate. Now you have a situation where there is no distinction on rates whether you derive income from business or you derive gains from capital asset which taxed at the same rate, it doesnt make any sense at all.   

Q: If the rates were lower, if they were in comparison to what the income tax slab rates are, if they were brought much lower for whether its long-term or short-term capital gains tax then this is okay with you, right?

Jhunjhunwala: No. I disagree. I dont say that there is a capital gain. In India there is a capital gain tax existing in the form of STT and it is now well administered in India; its well accepted, nobody is complaining about it. Tax which you get at such easy administration, with such little machinery, payable to you, no litigation, accepted by everybody- nobody is complaining and then you want to remove it.

Q: Obviously they are looking for more revenue, so there has got to be an in-between between having only STT?

Jhunjhunwala: How do we know that they will get more revenue?
Butani: The moot point over here is that is this new regime going to result in people being risk averse, people not wanting to invest their surpluses in the capital markets, I think thats the moot point.

Q: As an investor who has most of your money locked in to the fortunes of corporate India. What do you think of the proposal to levy Minimum Alternate Tax (MAT) at 2% of assets? Is that something that worries you as well that on April 1, 2011, if this code becomes law, you are going to hit not only by capital gains tax but a lot of the companies that you are invested in are probably going to suffer the short-end of the match stick?

Jhunjhunwala: There is one thing I want to state that let us not believe that by levying a capital gains tax on long-term capital gain; you are already levying it on short-term capital gain. What you are going to gain is the difference between the STT and what you collect as capital gains tax. So, I think with the ease of administration of STT and the acceptance, I see no reason why we should abolish.

Q: Would you be okay if the STT rates were increased?

Jhunjhunwala: Maybe markets in the short-term may not take it well. But thats a totally different question.

Q: If revenue generation is the big idea then thats the lesson of the devils if they increase STT?

Jhunjhunwala: But if you are going in for a regime where you want to have lower taxes; so you lower corporate taxation, you lower individual taxation and you take up STT. I dont think it goes with an idea of basic code here.

Q: Since considerable amount of your money, wealth is invested in equity shares of corporate India and the proposed change in taxation for many companies in corporate India is MAT?

Jhunjhunwala: What I personally feel is the MAT, the way they have suggested is not bad. What is debatable is the rate of tax and the time period within which a newly created capital asset will be subject to this tax. So, instead of 2 it could be 1.5, it could be 1. Second thing is if I create a capital asset at least you should allow me three-five years to make the capital asset profitable, so you can levy it on existing assets. I think all of us have to pay taxes.

Q: Would you say this code is investor friendly or not?

Jhunjhunwala: I agree with what Mukesh says that I dont know when it will come. You should also have a debate that will it ever come and in what form it will come because bills in parliament stuck for seven-seven years. So what I feel is let us judge what comes in the final form then we will be able to really debate whether its investor friendly or not.