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How the new Capital Gains Tax on shares will impact you

In a largely farmer oriented budget, the finance minister Arun Jaitley signalled a fundamental change in how Long Term Capital Gains is taxed on the sale of equity shares and equity oriented mutual funds. Was this tax warranted? Let us try to see the scenario we are operating in.

First of all, “Capital Gains” are those gains or profits made on selling “Capital Assets”. Capital Assets are those assets in which a person does not trade in, and expects to hold for a longer time. Classic examples could be personal houses, investments in the form of gold, shares, vehicles or any other asset. Profit on sale of such assets is deemed to be Capital Gains.

The Capital Gains are called “Long Term” when the above assets are ordinarily sold after holding them for 3 consecutive years. In the last budget this period of holding was reduced to 2 years in case of immovable property being land, building, and house property. Thus if you hold any of the above assets for 3 or 2 years as the case maybe, and then sell them, you would incur Capital Gains.

The gains are calculated as the difference between the selling price, and the cost price, after it has been adjusted for inflation. This adjustment is called “indexing”. The tax rate on all such gains is a flat 20% + surcharge and education cess, irrespective of your income tax slab.

Now read the above paragraph again, except bear in mind that all of the above does not apply to a specific class of assets:

  • Equity or preference shares in a company listed on a recognized stock exchange in India
  • Securities (like debentures, bonds, govt securities etc.) listed on a recognized stock exchange in India
  • Units of UTI, whether quoted or not
  • Units of equity oriented mutual fund, whether quoted or not
  • Zero coupon bonds, whether quoted or not

The above are mostly shares and stocks related instruments. Let us focus on equity shares i.e. shares one buys on the stock market and equity based mutual funds, since most of us would be exposed to that. Neither the 3/2 year holding period, neither the 20%(++) tax applied to such instruments.

The tax scheme for them was this:

  1. You need to hold them for just 1 year, to call it a Long Term Capital Asset
  2. The entire profit on sale was exempt
  3. Instead, you paid a flat tax of 0.1% or 0.025% on the traded value of shares. This is called Securities Transaction Tax

On the face of it, the tax benefits given to equity shares as compared to other class of assets are huge. The logical question would then be: Is it justified to give equity shares a special treatment?

As per a report of March 2015, only 16% of the share market was owned by retail investors i.e. common public. A more recent report, but of only 75 top companies, showed that only 7.9% of the shares of these companies were held by “Indian public”. Mutual funds held another 5.6%, which can be considered to be indirectly held by the Indian public itself. Promoters of the companies held close to 50% of the shares, so balance 30% odd can be attributed to foreign portfolio investors and institutional investors.

Irrespective of the exact figures, it will not be wrong to say that foreign portfolio investors and institutional investors, which are usually large corporates of wealthy businesses, own a substantial chunk of equity shares. Why then should they pay no tax on sale of shares held for over a year, but a common Indian man has to face a 20%(++) tax rate if he sells any other asset, even after holding it for 2/3 years?

This anomaly has been finally sought to be corrected in the current budget. The budget now proposes to tax such gains on sale of equity shares and equity oriented mutual funds, held for over a year, at 10%, if the gain exceeds Rs 1 lakh per person.

This provision achieves multiple objectives:

1. The limit of Rs 1 lakh ensures that small retail investors will not be touched by this tax.

2. The tax rate is a modest 10%, which is still far lower than the 20% on gains on other assets

3. The provision also has a clause which states that gains accrued till 31.01.2018 will not be taxed thus making it a prospective tax minimizing retrospective impact. This can be explained with an example:

Assume a share purchased on 30.06.2017 for Rs 100. You hold this share for say 15 months (making it a long term capital asset) and sell it on 30.09.2018 for Rs 150. The market value of the share on 31.01.2018 was Rs 120. The tax will be levied as below:

On Rs 120 – Rs 100 =  Profit of Rs 20 – NO TAX  i.e. no tax on capital gains till date prior to budget.

On Rs 150 – Rs 120 = Profit of Rs 30 – TAXED AT 10% i.e. tax only on the gains accrued post budget date. Again, this tax will apply only if the total capital gains exceed Rs 1 lakh

The exact provisions of the law can be debated i.e one could argue that only future purchases be taxed etc. But the broad logic and intention, i.e. to stop the preferential treatment given to equity shares over other assets is sound.

With this move, one holy cow in the business world has been touched by the allegedly “suit boot ki sarkar”. The impact of this move would be felt mostly by large-scale share holders and High Networth Individuals who have huge share holdings. The next bell to cat would have been the rich “farmers” since entire agricultural income, irrespective of amount, is currently tax free. Maybe next time?

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