Capital gains is the most complex topic in Indian taxation next to business income. It is also the subject that affects the entire investor community, be it investors in real estate, shares and other financial assets, bullion etc. This article focuses on the nuances of capital gains arising from sale of shares and other securities and the expectations from the upcoming budget.
In the year 2004-05, with a view to boost investments in listed equities, the government had removed long-term capital gains tax on equities and significantly reduced the tax rate on short-term capital gains.
To compensate for the revenue loss, the government introduced securities transaction tax (STT) on securities traded on stock exchange. This initiative was proposed to be a win-win for all and it indeed turned out to be so for the government and the investors as far as investments in equities are concerned. However, introduction of STT on other asset classes such as derivatives increased the transaction costs in those securities without any compensating relief in capital gains tax. Over the years, the investors have been requesting the government and hoping for a relief in either capital gains tax or STT on non-equity securities traded on the stock exchanges.
In 2018, the government re-introduced long-term capital gains tax on equities on the premise that a significant amount of income was going untaxed in the hands of corporates and LLPs and the investments were being diverted from manufacturing to financial assets. Though the government brought back long-term capital gains tax on equities, there is no corresponding relief provided from STT, which was originally introduced to compensate the government for the revenue loss it suffered due to lower capital gains tax on equities.
In most international markets, there is either capital gains tax or transaction tax on securities traded on stock exchanges but not both. In that sense, India is unique where both levies (STT and capital gains tax) are applicable. Given that all types of capital gains are now taxable, there is an expectation that the government should either abolish STT altogether or reduce the STT rate significantly.
While re-introducing long-term capital gains tax on equities in 2018, the gains arising to investors as on 31 January 2018 were grandfathered to avoid any retrospective impact of the newly introduced tax. Under the grandfathering provisions, the original cost of acquisition of shares is stepped up to the highest trading price of the stock on 31 January 2018, capped to the actual sale consideration.
Though grandfathering provisions were a big relief to long-term investors, there is uncertainty on whether shares received through corporate actions viz. sub-division, merger, demerger (resultant shares) post January 31, 2018 would qualify for the grandfathering benefit if the original shares were purchased on or before 31 January 2018. The uncertainty arises since grandfathering benefits are available to shares "acquired" on or before 31 January 2018.
Given that the law otherwise allows a taxpayer to take into account the original cost of acquisition and holding period for computing capital gains from resultant shares, there is an expectation that a clarification should be issued to the effect that grandfathering benefit would be available on shares received in a corporate action post January 31, 2018 provided the original shares were acquired on or before such date.
In the Indian capital gains tax regime, bonus shares are not allocated any cost since they are issued by companies to shareholders free of cost. As a result, upon sale of bonus shares, the entire sale consideration is taxed as short term / long term capital gains depending upon the period for which they are held. This treatment can result in higher taxation in certain situations.
Let's look at a situation, where an investor has held shares of a company for more than one year, receives bonus shares and sells off the entire shareholding (i.e. original shares as well as bonus shares) within one year of receipt of bonus shares. In such a situation, the sale of original shares would typically result in long term loss to the investor (since the stock price would typically fall post bonus issue) and the sale of bonus shares would result in short term gains.
Since the law does not allow long-term loss to be offset against short term gains, the investor would need to pay full tax on short term gains which would be significant since no cost is associated with bonus shares. To avoid such a situation, the government can consider to replicate the practice followed in certain developed countries whereby the original cost of acquisition is distributed amongst the original and bonus shares in the appropriate ratio.
There has been a fair bit of litigation in the past on classification of income from sale of property as capital gains or business income, especially on sale of shares and other securities. In 2016, the Central Board of Direct Taxes issued circulars to provide clarity that if a taxpayer treats gains from transfer of listed shares and securities held for more than one year as long term capital gains, it should not be disputed by tax authorities.
A similar clarity was provided for sale of unlisted shares in the year 2017 subject to certain conditions. These circulars have provided a lot of certainty to investors and would go a long way in reducing litigation on this aspect.
Also, there is clarity in the law that transfer of securities held by Foreign Portfolio Investors would be taxed as capital gains. Nonetheless, there are a few areas that require clarity and certainty. For instance, it is not clear whether gains arising to a person from entering into derivatives especially when the person is a writer of options contract would result in capital gains or business income or other income.
Similarly, there is uncertainty on whether income arising to an Alternative Investment Fund from sale of listed shares held for less than one year would be classified as capital gains or business income. The government can consider issuing a clarification that gains derived by any person from trading in exchange traded derivatives should be classified as capital gains.
In addition, the government can consider amending the definition of capital assets to the effect that any securities held by an AIF would be classified as capital assets.
(Rajesh Gandhi is Partner, Deloitte India and Karamjeet Singh is Director with Deloitte Haskins and Sells LLP)