TAX NEWS - June 2010

India Tax: Short-term gains - more tax at higher slabs

Jun. 17, 2010 -- Though the revised Direct Tax Code (DTC) has diluted the earlier proposals of the August 2009 discussion paper, a short-term gain will now be taxed at the income-tax (I-T) rates to which the investor belongs. Long-term gains will also be clubbed with income, but not all the profit will be taxed. The proportion of profit to be taxed will be announced by the government later.

Note that the definition of what constitutes long term and short term will be changed if the proposed DTC norms are accepted. If you wish to qualify your equity-oriented mutual fund or equity investments for long-term benefits, you will need to hold your asset for at least a year after the end of the financial year in which you invest.

So, if you invest on 1 June 2010 (assuming DTC is already present), you will need to hold your assets till, at least, 31 March 2012, and not 1 June 2011 when your investments would actually complete a year of investment. Since you would have invested in June 2010 and it falls in the financial year of 2010-2011, the end of this fiscal falls on 31 March 2011. Your investments would need to complete one year after this date.

Currently, short-term profits from the stock market are taxed at 15%, but if this DTC becomes the rule, then all profits from holding a stock or an equity fund for less than a year will be clubbed with your income and be taxed at your marginal tax rate. If you make a short-term gain of Rs5 lakh and come in the 30% tax bracket, today you pay Rs75,000 as tax (15%); post-DTC you will pay Rs1.5 lakh (30%). The impact for the person in the 10% tax bracket is positive, as he now pays Rs75,000 and post-DTC will pay Rs50,000 (10%).

If you book profits on your equity funds after a year of the end of the financial year in which you invest, the income-tax department will allow a tax deduction rate. This rate will be a percentage of your capital gains and will be exempt from the income tax. The balance amount will be taxed as per your income-tax rates.

Assume you make a capital gain of Rs4 lakh in your equity fund. Also, assume that the capital gains deduction rate is fixed at 50%. This means that you do not pay tax on half your capital gains (of Rs4 lakh). The remaining Rs2 lakh will be taxed as per your income-tax rates. If you fall in the 10% tax rate, you pay just Rs20,000, or 5%. Investors in the 30% tax bracket will pay Rs60,000, or an effective tax of 15% of the profits. If the tax deduction rate is fixed at 70%, your effective tax rate will drop to just 3% of your profits, assuming you fall in the lowest (10%) income-tax bracket.

"It is left to the income-tax authorities to decide the tax deduction rate, but we can expect it to be between 40% and 60%. I think the authorities will continue to encourage long-term investing. The rate, therefore, has to be beneficial", says A. Balasubramanian, chief executive officer, Birla Sun Life Asset Management Co. Ltd.

Once DTC comes into effect, experts predict that investors might be tempted to invest during the end of the financial year. "Since investments need to complete a year from the end of the financial year in which you invest, those investors wishing to speculate would push their investments to during the end of the financial year. But this won't matter to those investors who wish to genuinely invest", says Sandip Mukherjee, executive director for tax and regulatory services, PricewaterhouseCoopers.

Many fund managers predict investors could be tempted to book profits before the DTC comes into effect on 1 April 2011. "It will also depend on the market levels prevailing then, but investors may be tempted to book profits and avail of the zero capital gains regime that will expire once DTC takes effect", says Sanjay Sinha, chief executive officer, L&T Investment Management Ltd.

Debt fund investments will not get the benefit of the special tax deduction rate. However, if you sell your debt funds after a year (the one-year definition remains the same), you will get the benefit of indexation. Your indexed gains will be clubbed with your income and taxed at income tax rates. Adds Sinha: "This won't make much difference to debt fund investors as they invest in debt funds not so much from the tax-saving point of view as much as to avoid the volatility of equity markets."