Equity capital gains are free if you sell shares after a year. You don’t pay long term capital gains taxes for shares sold on a stock exchange.

But if you look at other “assets”, equity is getting a great deal:

  • For gold, you have to hold for three years before you get “long term” gains, which are taxed at 20%.
  • For real estate the house has to be held for three years, and again 20% gains taxes apply (though taxes can be offset if you buy a new house)
  • For debt mutual funds you have now hold for three years before you can apply “indexation” benefits and claim long term capital gains (which are 20% of indexed gains, or 10% of unindexed gains, whichever is lower)
  • For unlisted companies, you pay 20% capital gains taxes if you sell shares after a year. (This is still one year, but the taxes are large)

Listed stocks are the only real asset class where, after just one year, you pay no taxes whatsoever.

This is being abused to launder black money

Consider this scheme:

  • A person called “Bhushan” owning shares in “black” buys 5 crore shares today, of a small listed company, in a preferential deal at Rs. 1 per share
  • Some operators do circular trading and move the share price up to Rs. 500 per share.
  • This process is done over one year.
  • “Bhushan” then transfers Rs. 2500 crores in black money out of India through the hawala mechanism to a foreign country.
  • This money in the foreign country is then put in an “FPI” (a foreign portfolio investors) which has big names in it like Merrill Lynch and so on. Because to them, the foreign entity is legit.
  • That FPI account then buys this Rs. 500 share from “Bhushan” at that massive valuation, from the market, for Rs. 2500 crores.
  • “Bhushan” now pays zero taxes, because the capital gains on his investment is Long Term (more than 1 year).
  • “Bhushan” has just converted Rs. 2500 cr. from black to white money!

This is not an insane case. Recently, SEBI banned 260 entities for doing something like this, including the promoters of the troubled Bhushan Steel.

[blurb-capmind-prem]

 

I will submit that you could do this over one year, but if it were any longer, say three years, then such manipulation would be very risky (because SEBI, which acts after one year anyway, will probably be able to detect and trace such manipulations).

The Tax Benefit Has Achieved Its Goal

One reason to provide the tax-free gains for equity shares was because the stock market was under-served and to promote investment. This has achieved its purpose. More investments are coming into the market than ever before. And the market is near or at all time highs.

The need now might be to promote longer term investments. As India matures, long term will mean three years, not one.

And the Government’s Running Out Of Money

And then, we know that the government has no money. It’s running a huge budget deficit due to lower tax collections and stable expenditure (which it’s trying to cut because it is not able to earn enough by way of taxes).

See: Fiscal Deficit Higher, at 99% of it’s Full Year Target as of November 2014

Here It Comes: Remove the One Year Tax-Free Benefit for Equity Shares

We know that:

  • In no other asset class do you get tax free gains after one year – at best, it’s after three years.
  • The one year tax-free gains benefit is being abused to launder money; it will be reduced if such tax free gains were only available after three years.
  • There’s no reason to promote “one year” as a long term investment time frame – like in debt funds or gold, three years is the new long term.
  • The government needs revenue desperately. It will have to raise taxes.

Given this, and given that we have a budget coming next months, here’s what I think should happen:

The Government Should Make Equity Gains Tax Free Only After Three Years

This would make perfect sense, and is quite a logical thing according to me. You buy and wait till three years after you’ve bought, then gains are tax-free. Otherwise, you pay capital gains taxes.

My Goodness, Deepak, are you Stupid? Who the heck will pay short term cap gains till three years?

I didn’t say you would pay short-term gains taxes. You will pay long term capital gains tax after one year. This is 10% of your gains, (or 20% if you index with inflation, whichever is lower).

So if you hold for a year, you still pay a lower tax rate. But it won’t be zero. For Less than a Year, nothing changes – the tax is around 15%.

If you hold for three years, it will be zero tax on gains.

Won’t The Stock Market Tank?

Yes, it will. Firstly people will know that the budget will come in February, but only be applicable after March 31. So if you bought between April 2012 and March 2014, you want to sell your shares and reinvest them. (Why? Because your purchases prior to 2012 will still be tax free as they are three years or more away. If you bought after April 2014, you have to wait one year to get tax-free gains anyway, so no point selling now)

This is probably a small subset of people, but their selling and the general media outrage (because the media is known to get all sentimental about things like this) will cause some damage.

But realization will dawn very soon that:

  • This is not a bad thing
  • Foreigners don’t get impacted at all (since they pay capital gains taxes where they reside, which might be zero anyhow)
  • Some FIIs which were designed to be black money laundering entities will shut shop. But that just means they will be replaced by “proper” entities.

So what if the market tanks? If it’s the right thing to do, it’s what should be done. Markets will go down and up based on what they want.

Will This Happen?

I think it should, but I have no inside information that it will. This is a great time to do it. This government has only four budgets left, really: 2015, 2016, 2017 and 2018.

If you think about it, 2016 or 2017 has to be a blockbuster budget. 2018 will be okay, because that’ll just ride the momentum. So the only budget to do a massive cleanup/kitchen sink is: 2015. That’s now a month away. This budget could be the one that is “horrible”.

If this is a budget to clean up the mess, I think we should increase the term for tax-free long term gains to a holding period of three years.

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