Union Budget: Tax Policy Concerns for Capital Gains and Dividend Distribution on Mutual Funds

[Hardeep Singh Chawla is an Advocate practicing in the M&A & PE Tax Department of a Big4 in Gurgaon, Haryana. Views expressed are his own. The author may be reached at [email protected]]

“The only difference between death and taxes is that death doesn’t get worse every time Congress meets” – Will Rogers

Recently the Finance Minister tabled the Finance Bill, 2018 (‘Bill’) in Parliament which, among other things, proposes to insert a new section 112A in the Income-tax Act, 1961 (‘Act’) which provides for levying tax on long term capital gains (‘LTCG’) tax at the rate of 10% (without giving the benefit of indexation) on sale of equity shares and units of equity-oriented mutual funds (‘MFs’) provided that the gains exceed INR 1,00,000 in a given financial year. Given that these transactions were not taxable upto FY 18 the cost of acquisition for the purposes of computing LTCG has been grandfathered. Further, the Bill proposes to insert section 115R in the Act which levies dividend distribution tax (‘DDT’) at the rate of 10% on the income distributed by an equity oriented fund to the unit holders.

For the purposes of this post, I have not delved into the merits of having an LTCG regime for equity shares or MFs; I have, however, juxtaposed these provisions against the established canons of tax policy as enumerated by Adam Smith in the Wealth of Nations which are – ability, certainty, convenience and economy.

Taxing LTCG on Systematic Transfer Plan (STP)

In a MF setting, STPs are used as an instrument to maintain economic efficiency, wherein an investor may transfer its invested amount (including gains) from one fund or scheme to another if the initial fund or scheme fails to perform as per expectations. The mechanics include extinguishing the units of the initial scheme and purchasing new units in the desired scheme. While the investor has not realized any gains for disposal purposes, they have re-invested the gains in another scheme or fund.

Here lies the principle of economy, wherein no tax should aid in creating inefficiencies in the economy. In the current form, the proposed section is drafted in such a manner whereby the LTCG is exigible on STPs leading to the creation of long term inefficiencies in the market – where the individual investor keeps the current investment intact and is hesitant to transfer their investment to a better performing scheme.

Therefore, an exception should be carved out in this regard in section 47 of the Act – Transactions not regarded as transfer to exempt such transfer(s) leading to efficiency in the market.   

Dividend Distribution Tax on Equity Mutual Funds

The second proposal deals with levying DDT at the rate of 10% on the income distributed by the MF. In this case it may be pertinent to note that large parts of asset allocation of such MFs shall be equity shares; in which case there is apparent double taxation – the company distributes income, such income is exigible to DDT, such DDT-deducted funds are received in the hands of the MFs and MFs in turn discharge DDT (on the same funds) while distributing the income in the hands of the individual investor.

Double taxation is magnified since these are equity-oriented mutual funds and as such by definition are required to maintain a minimum 65% holding of equity companies and, therefore, it is highly likely that these MFs individually would also earn income by way of dividends distributed by the companies on which the companies would have paid DDT.

Since these MFs are held to create a regular stream of income in the hand of the individual investor and levying DDT again on the same stream of income (to the extent applicable) may make the dividend-yielding MFs unattractive to individual investors vis-à-vis holding stock (having a track record of distributing income) directly in the personal capacity of such investor.  

Therefore, in light of the above, apparent double taxation should be avoided and suitable amendments should be made to proposed law.

Securities Transaction Tax Levied along with LTCG

Securities Transaction Tax (‘STT’) was introduced by way of the Finance Act, 2004 which provided for an exemption on LTCG in lieu of the STT.

The memorandum to the Finance Bill, 2014 states:

With a view to simplify the tax regime on securities transaction, it is proposed to levy a tax at the rate of 0.15% on the value of all the transactions of purchase of securities that take place on a recognized stock exchange in India… Further, it is proposed to insert clause (38) in Section 10 of the Income-tax Act, so to provide exemption from long term capital gain arising out of securities sold on the stock exchange.

The Bill proposes to levy both the STT and the LTCG thereby causing two different taxes to be imposed on a single transaction. Transaction taxes act as a disincentive to transactions. Since STT was until now levied in lieu of LTCG (because of administrative efficiencies), STT was saved from this observation. In the Bill, both of these taxes exist together and therefore the jurisprudential basis of having an STT regime is lost.

Further, where the trading cost is less than the cost of STT, large institutional investors may shift trades to other jurisdictions to save them from these taxes and that may have a repercussion on the Indian capital markets as well. 

The Grandfathering Provision for Computing LTCG – 31 January 2018

The proposed section defines the “fair market value” (‘FMV’) as the ‘…highest price of capital asset quoted on such exchange on the 31st day of January, 2018”.

It is pertinent to note here that picking the previous day (on ad-hoc basis) in the backdrop of the announcement of the Union Budget seems arbitrary and unjust especially for the purpose for which it is important – calculating the grandfathering value.

The intention to grandfather the gains made before the proposal to levy LTCG is that the assessee did not expect to pay LTCG until FY 18 and therefore to make the law prospective, the gains would not be exigible to tax. 

However, there exists a possibility that the share price quoted on that particular date was not the highest that someone could fetch in the open market and since it was not taxable during the prior period too (meaning thereby that the law is prospective), a better view would have been to allow FMV to be determined from the highest price during a period (let’s say a month) or the average of the highest price. This would have been fairer and equitable to the stakeholders given the volatility that the stock market faces.

These proposals need closer analysis from a tax policy perspective and merit greater public discussion before the Bill finally becomes law.

– Hardeep Singh Chawla

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