TAX NEWS - 2010

Direct Tax Code (DTC): Long and short of capital gains

The first version of Direct Tax Code (DTC I) was based on simplicity in the interest of revenue; the second (DTC II) is more rational but not without significant exceptions.

In capital gains taxation the distinction between short term and long term is critical.

For, trading in stocks is regular business and implicitly means that the asset is held only for a short term. What that short term should be may be differently interpreted. Most countries accept that it should be less than a year. While accepting this norm, DTC II, however, puts a twist on it.

The year is defined as a year from the end of the financial year in which the securities had been purchased. That means that if the security was purchased on, say, 1st April 2010 it will be deemed to have been held for one year only on 30th March of 2012.

The one year period can thus vary from 12 months + one day to 24 months + one day. Undoubtedly odd. But it converts a part of the long term gain under the present system into short term gain under the new system, resulting in more revenue to the exchequer.

The largest investors are the FIIs who have been using the lack of clarity in the present tax system to their own advantage. Some have been declaring their income as business income and others as capital gain resulting in avoidable litigation. DTC II turns all income into capital gains which permits, if advantageous, recourse to tax treaties for tax exemption.

Capital gains earned from securities held for long term (more than a year), are taxed differently. Presently they are totally exempt from tax. The justification is that taxation of long term capital gains results in double taxation, first of the income from the asset and second from the asset itself when it is sold.

DCT II does not exempt such gains from tax though it moderates the incidence of taxation by taxing only a part of the gains which may be 30-50 per cent at the marginal rate applicable to the tax payer.

Long term is now the same for all assets. For capital gains tax on non-financial assets, the minimum holding period for tax benefit is down from three years to one year. The investor will continue to benefit from indexation, as before, to mitigate the impact of inflation. The balance gains will be added to the income of the investor and charged at the applicable rate.

The long and short of DTC II is that more of the FIIs will be able to claim exemption under double tax avoidance treaties and reduce their tax liability; domestic investors will be pay higher taxes on capital gains since DTC II abandons the principle of zero tax on long term capital gains. Although DTC II is an improvement over DTC I, the bias in favour of revenue is not lost.