Direct Tax Code: Go Short or Go Long, but Pay Up

The new tax law may penalise long-term investors

Published: Jan 22, 2010

Most finance ministers in the past gave direct tax reforms a miss, preferring discretion to valour, until P. Chidambaram took the bull by its horns and drafted a new code to replace the Income Tax Act of 1961. The new code is expected to simplify the tax procedures and adopt international best practices. But it could be tough on investors because their overall tax burden is likely to increase.

The biggest blow to investors is the removal of tax exemption for long-term capital gains. The code proposes abolishing the securities transaction tax of 0.25 percent, which by itself, would have been welcome. But the code also imposes capital gains tax on all gains made by selling shares, irrespective of the time they were held for. Thus it eliminates the distinction between short-term and long-term gains.

Earlier, gains from the sale of shares after one year were tax-free. Now they will be clubbed with your income and charged at the slab rates going up to 30 percent.

 

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Illustration: Malay Karmakar


The tax code introduces the ‘Exempt-Exempt-Taxation’ (EET) method for savings. Under this method, investors will enjoy tax benefits at the time of investment and growth, but will be taxed when they withdraw the money. Earlier, investments enjoyed tax benefits on all the three legs, under the Exempt-Exempt-Exempt system. The only saving grace here is that contributions made to provident and pension funds schemes until March 31, 2011, will continue to enjoy the full exemption.

A key segment to be hit from the EET system will be equity-linked savings schemes (ELSS). These schemes are popular with tax savers. But the new system could make ELSS dividends taxable.
Hiresh Wadhwani, partner at Ernst & Young, says the DTC is doing things backwards. He says the code accords tax benefit to a saver when he has earning potential, but will tax him in his old age. “This might work better in a developed country but not in India. We need a TEE system, Tax-Exempt-Exempt, for the Indian context,” he says.

The burden of wealth tax is also likely to increase. Surely, the code proposes raising the exemption on wealth tax to Rs.50 crore and a tax of 0.25 percent for wealth above that threshold. That is, a wealth of Rs. 51 crore will attract a tax of only Rs. 25,000. Sounds good. But the definition of “wealth” has now been expanded to include shares and financial instruments.

So, even promoter holdings in companies become taxable. “But even then, it’s a minimal rate. I think it’s quite fair, especially for rich promoters who have multiple holdings on listed entities, as they will see increased outflows annually,” says Uday Ved, head of tax at KPMG India.

The direct tax code is not yet law and the government is reviewing many aspects of it. It might be a bit harsh on the investors in the form P. Chidambaram got it drafted when he was finance minister, but there is still hope that Pranab Mukherjee may soften it a bit.

 

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  • Mustafa M

    I am surprised that people are vocal against EET .. with funny "arguments like benefit to a saver when he has earning potential, but will tax him in his old age".<br /> <br /> EET is the right way. <br /> <br /> It will encourage saving (capital & tax) during the peak earning (and hence taxation) years. <br /> <br /> Tax will be deducted typically at a time when the person would not have any other income (i.e. after retirement) with an expectation that tax liability (slab) will also be lower.<br /> <br /> It will also increase the returns, as instead of taxing upfront and been paid to govt, the tax will get "invested" and more than pay for the deduction in later years.

    on Apr 1, 2010
  • Ashish Jaiswal

    The EET mechanism proposed in the Direct Tax Code is not suitable for Indian context. In India we should encourage investment/saving by middle class. Further, the taxability of Long Term Capital Gain should also need reconsideration.

    on Jan 25, 2010
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