Reforming the capital gains tax a smart move

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Reforming the capital gains tax a smart move

Saturday, 01 April 2023 | Uttam Gupta

Reforming the capital gains tax a smart move

It is perfectly justified if the rich class is made to pay more which, in turn, helps the Government provide services to the poor

In the Finance Bill, 2023 passed by the Lok Sabha on March 24, 2023, an amendment relates to a change in the tax treatment of capital gains from non-equity or debt mutual funds (DMF). This has led to consternation in the investor fraternity including high net-worth individuals (HNIs), corporate, and so on who argue this will undermine efforts to deepen the bond market which is crucial for financing the long-term development needs of the economy.

They also say such a change should have been introduced in the Union Budget. This would allow for thorough discussion in Parliament, instead of an official amendment. Now that it is part of the Finance Act, any discussion on the procedure adopted is merely academic. Before discussing the amendment that will take effect from April 1, 2023, let us look at the existing position. DMF is a scheme that invests in fixed income instruments, such as corporate and government bonds, corporate debt securities, and money market instruments etc. that offer capital appreciation. Debt funds are also called income or bond funds.

Currently, any capital gain on redemption of units in a debt fund held for three years or longer is treated as long-term capital gain (LTCG) and is taxed at a flat 20 percent with the benefit of indexation (it adjusts the cost of a person’s investment to account for inflation, effectively reducing her capital gains and in turn, her tax liability). Any capital gain on redemption of units held by investors before three years is treated as short-term capital gain (STCG) and is taxed at an individual’s income tax (albeit personal) slab rate.

The amendment does away with this distinction in the case of ‘Specified mutual funds’ (SMFs) which essentially refer to mutual funds where not more than 35 percent of their total proceeds are invested in equity shares of domestic companies. As a result, gains arising from SMFs irrespective of the period for which the units are held by investors are deemed STCGs and hence, liable to tax at the rate applicable to the slab in which their total income falls.

Given the way SMFs are defined, the new tax treatment will also apply to exchange-traded funds (ETFs), international funds, gold/silver funds, outbound mutual funds and even equity funds etc. wherein the gains will be taxed at the personal income tax (PIT) slab rate. The amendment will be applied prospectively from April 1, 2023. This implies that all MF units already in possession of the investors as well as those acquired before this date will continue to be covered by the old dispensation.

 Impact on investors

Consider a high-income earner earning Rs 2 crore per annum. The applicable effective tax rate in her case is 39 per cent. Assume she has invested Rs 100 in DMF units which yield a return of 10 percent per annum. Further, assume that inflation is 5 percent. With these basics, under the old regime i.e., 20 per cent LTCG tax with indexation benefit, her gain at the end of three years would be Rs 17.4 (value of investment Rs 133.1 minus inflation adjusted cost Rs 115.7). Tax @20 per cent on Rs 17.4 comes to Rs 3.5. Under the new regime i.e., tax rate in the relevant slab (39 per cent in this example) and no benefit of indexation, capital gain at the end of three years will be Rs 33.1 (value of investment Rs 133.1 minus cost Rs 100). Tax @39 per cent on Rs 33.1 will be Rs 12.9 which is almost 4 times the tax under the previous regime. It is this steep increase in the tax burden that is hurting the high-income earners.

We need to look at things from the perspective of the government which is expected to make laws with the objective of inclusive growth that address the concerns of all sections of society and not just pander to the interests of a particular class. If the rich class is made to pay more resulting in more revenue for the government. This in turn, helps it cater to the majority of the poor, this is perfectly justified.

Even so, the existing taxation regime was arbitrary, inequitable and customized to grant undue benefit to HNIs/corporate etc. Income earned by a person has no colour. Irrespective of the source from where earnings are made be it salary, profit from business, investment in shares, bonds or mutual funds and so on, these add to her income. Therefore, the tax treatment must be uniform. It can’t vary depending on the source.

Yet, the regime gave preferential treatment to income generated from DMF investment by taxing capital gains from these at 20 percent against the applicable slab rate of 39 percent. It was discriminatory even compared to investment in other avenues. For instance, interest income from investment in fixed deposits (FDs) in banks or bonds issued by governments or companies is taxed at an individual’s income tax slab rate. These earnings don’t also benefit from indexation.

While HNIs should have no grudges about paying more tax, those earning less, especially the middle class, will not stand to lose in the new dispensation. Under the proposed PIT regime as per the 2023-24 Budget, a person with annual income up to Rs 700,000 pays ‘nil’ tax. For those earning Rs 700,001-Rs 900,000, the tax rate is 10 percent and for those earning Rs 900,001-Rs 1,200,000, it is 15 per cent. For all investing in DMFs, the switch to taxing capital gains at the applicable slab rate will be beneficial. Under the earlier regime, these were taxed at a higher rate of 20 percent.

The Finance Bill, 2023 also addressed another anomaly. This one relates to a fancy instrument called market-linked debentures (MLDs). Unlike a normal debenture on which a fixed return is paid, MLD holders get a return linked to stock price movement, say the Nifty 50 Index. Earlier capital gains from listed MLDs were taxable at 10 per cent if held for more than a year. They were also taxable at a slab rate if held for up to 1 year. Now, these will be taxed at the slab rate even when owned for more than one year.

To conclude, the 2023-24 budget has ended DMF preferential treatment by taxing all capital gains — irrespective of the holding period — at the slab rate and withdrawing the indexation benefit. It has created a level playing field by aligning their tax treatment with other avenues such as FDs and bonds etc. It would be naïve to believe that this would lower the shine of such instruments (read: debt MFs) as investment in these units is liquid; it can be withdrawn at any time unlike FDs where premature withdrawal attracts a penal interest rate. Besides, the former offer investors the possibility of setting off capital gains in some units by short-term capital losses in others thereby reducing tax liability. Any fear that the amendment would impact funding the long-term development needs of the economy is without any basis.

(The writer is a policy analyst)

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