Indian stock markets may have seen a bull run that propelled the Bombay Stock Exchange benchmark, the Sensex, beyond the 20,000 points range early last year. The market went on to plunge before starting to recover in March this year, although it is way below the record it scaled in those heady days.
Despite the volatility, retail investors have not entirely shied away. In recent years, Indian capital markets have undergone a sea change and a variety of new financial products such as derivatives, futures and options have been introduced, in addition to plain-vanilla equity or debt investments.
Indian tax laws need to progress to be in step with these instruments and the needs of today’s capital markets.
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Some of the key issues that revolve around capital market taxation which need to be addressed as a step forward towards rationalization/simplification are:
Investment income vis-à-vis business income: The very crux of litigation as regards taxation of capital market transactions is the lack of clarity on whether to treat a taxpayer as a trader or investor. There is a significant difference in the applicable tax rates depending upon the nature of income (whether it is investment income or business income). Unfortunately this is a matter of dispute with the tax authorities.
The issue is even more complex because of the difference in tax rates imposed on investment transactions as opposed to business transactions (the latter being generally higher).
This issue stands unresolved even after certain tax judgements and a Central Board of Direct Taxes circular which failed to provide useful guidance on the issue and so subjectivity continues in the course of tax assessments.
One of the ways through which this issue could be resolved is through introduction of deeming provisions in the Income-tax Act, whereby every transaction is deemed to be in the nature of an investment unless specified criteria are met so as to qualify the taxpayer/transaction as that of trader/business transaction.
Such criteria could be:
• The number of transactions entered into during the year
• “Other receipts” being more than the receipts from the capital market transactions
• The size of the use of debt for purchase of shares/other instruments.
A clear set of standards on which to judge the taxpayer (whether he is an investor or a business person) or the transaction (whether an investment or business transaction) would provide clarity, especially to retail investors, by addressing the ambiguity involved and minimizing litigation costs.
Allowance of expenses in relation to dividend income in case shares are treated as stock in trade: As dividend income is currently exempt in the hands of shareholders, the current tax provisions do not allow deduction of corresponding expenses for earning dividend income.
However, this results in an anomalous situation for taxpayers who are into the business of trading shares. The total returns to a trader comprise both dividend as well as value appreciation. In such cases, disallowance of regular business expenses in proportion to dividend income causes a lot of hardship as dividend income fluctuates a lot, depending upon dividend policy and market situation, whereas expenses incurred in such business are more or less steady.
In this regard, a share trader may be given an option not to treat dividend income as exempt and pay taxes after allowance of expenses incurred in earning such dividends and proportional deemed credit in respect of dividend distribution tax paid by the company in which the share trader has invested.
Taxability of derivatives including options and futures: A derivative instrument is a contract (an enforceable right capable being traded on the stock exchange) that derives its value from the value of an underlying asset. It has played a vital role in ensuring that underlying shares are traded at a fair price.
It may, therefore, be considered at par with other capital assets that are capable of being traded.
However, Indian tax laws do not define whether a derivative (option as well as future) is a capital asset or not.
The computation of capital gain/loss from future transaction may be done by treating the strike price as the cost of acquisition and the market price on the date of settlement as the sale consideration.
However, as regards computation of capital gain/loss from option (not exercised), there is indeed a problem in fitting it in the traditional scheme of computing capital gains/losses. A provision may be introduced to deem the premium as capital gain. As an outcome, it would become clear to the investors that the income earned is subject to capital gains unless the same is treated as stock in trade (and hence considered as business income).
Index futures—whether speculative transactions: Under the tax laws, non-delivery-based transactions are considered speculative and losses from such transactions can be set off only against profits of another speculation business and not from normal business.
If speculation profits are insufficient, such losses can be carried forward for eight years, and will be set off against speculation profits in these future years.
The Finance Act, 2005, deemed certain transactions carried on recognized stock exchanges as non-speculative transactions in spite of their being non-delivery-based transactions keeping in perspective, the importance of these transactions in determining a fair price, providing liquidity to shareholders and addressing genuine business hedging transactions.
Currently, there is an ambiguity whether hedging contracts through the mechanism of index futures will be considered speculative or not as index futures are neither “commodities” nor “stocks and shares”. This issue also requires a resolution.
Levy of minimum alternate tax (MAT) on long-term capital gains from shares : MAT was levied to bring into the tax net the companies not liable to pay tax under the normal tax provisions. Hence, where a transaction is already in the tax net, there is no case for levying MAT.
Long-term capital gains not liable to securities transaction tax are taxed at 10% which is same as the tax rate under MAT provisions. Thus, long-term capital gains arising from shares must be kept outside the levy of MAT.
Capital market taxation suffers from various loopholes which need to be addressed. Efficient and well-regulated capital markets are significant determinants of growth for an economy. With the Indian capital market adopting new and innovative financial instruments, a conducive tax environment is essential for its growth.
Ganesh Raj is tax partner, policy advisory group, Ernst and Young. This is the second of a four-part series on key issues which need to be addressed by the proposed overhaul of the direct tax code. Respond to this column at email@example.com