Chanakya's way: 3 soft tricks Arun Jaitley may play to tax capital gains

He is damned if he does and damned if he does not. Finance Minister Arun Jaitley, who is due to present India's budget for 2017/18 on February 1, has the onerous task of raising the country's tax revenues without the stock markets frowning on him. The ropewalk is a tough one because of the limited success - at best -- of the demonetisation of 500 and 1,000-rupee notes that has somewhat dented the Narendra Modi government's political image.

With GDP growth slowing and everything from US President Donald Trump's protectionist economics and sluggish recovery in Europe and shakiness in China's economy worrying market players (Read: foreign institutional investors who in turn drive domestic mood in India), one would expect measures from Jaitley to preserve India's image as an oasis of high-growth and market-friendliness on the planet.

Speaking three weeks after his demonetisation gamble, Modi said capital markets need to contribute more to the taxman.“Those who profit from financial markets must make a fair contribution to nation-building through taxes," he said in a speech that immediatley invited a clarification from Jaitley, that this does not mean the imposition of a long-term capital gains tax.

 Chanakyas way: 3 soft tricks Arun Jaitley may play to tax capital gains

Arun Jaitley. Reuters

Capital gains on shares are now tax-free if investors hold on to them for a year -- defined as long-term. If they are held for less than a year, the short-term rate is a modest 15 percent. Bonds or bond funds held for more than a year attract income tax at 10 percent without inflation adjustment and 20 percent with inflation adjustment.

What will Jaitley do now? In the wake of criticism that rich folks are getting way with low or no tax, and with his need to keep fiscal discipline, it makes sense for the minister to tax capital gains -- which were exempt in the spirit of the reformist 1990s to encourage wealth creation. To avoid a rash market backlash, there are at least three ways he might soften the blow while managing to target capital gains.

1) He may extend the holding period for shares for their sale to qualify as long-term one. Some hints from the government seem to suggest this is already on the table.
2) The minister may come out with special provisions so that capital gains reinvested in productive activities such infrastructure building may be exempt from taxation. We already have Section 54 of the Income Tax Act under which gains from long-term capital assets such as property enjoy exemptions if reinvested in a certain manner or if they are parked in specified bonds (under Section 54EC) issued by bodies such as the Rural Electrification Corporation or the National Highways Authority of India and held for a specified period. The minister may well include gains from shares or debt funds under such provisions or tighten the provisions so that some part of the capital gains effectively comes into the government kitty.
3) The government may introduce some kind of a portfolio tax based on overall value of shares or securities held. With demat (dematerialised) accounts being the norm for holding all sorts of securities, and with a tax-linked PAN number in place, demat accounts are easy to tax. As many as 2.4 million demat accounts were opened in 2016 alone, while the overall number of demat accounts in India stands at about 27 million or more . Now, less than 600,000 taxpayers showed short-term gains or losses in 2012, indicating that only a fraction of the potential base for capital gains was in the tax net.

India's overall taxpayer base in a nation of 125 crore (1.25 billion) people is only 48 million, or 4.8 crore -- or 3.8 percent of the population. Demat portfolios may widen the net. Portfolio managers and demat service providers typically charge fees linked to overall portfolio value. The government may well join the party by asking for a teeny fraction of the same. Given the BJP's inclination towards Chanakya's philosophy, this should be a minimally invasive way of capital gains taxation. It also echoes Ved Vyasa, who is quoted as saying in the Mahabharata that governments must collect taxes like bees gather honey .

(The author is a senior journalist. He tweets as @madversity)

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Updated Date: Jan 27, 2017 12:04:16 IST