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Transaction tax simplified

August 07, 2004

Over the past week, I have received numerous queries about the applicability of the new Securities Transaction Tax and the exemption extended to shares and units from long-term capital gains.

The biggest worry of most investors -- both in equity and mutual funds -- seems to be whether the changes affect existing investments or only those that are bought under the new regime? What if one buys shares/units today and sells after two months? Will the short-term gains be taxed separately at 10 per cent or would it be added to normal income and brought to tax at the rates applicable otherwise? What about STT? STT has not been paid for existing investments.

In such cases, would the long-term capital gains tax exemption apply or will it be applicable only on such investments that STT is paid for? Day traders have an altogether different dilemma.

On the one hand they are happy that the STT payable by them is much lower at 0.015 per cent and even this can be set-off against the tax payable on business income. If this is indeed so, they ask if the tax payable on normal business income happens to be lower than the total STT paid, will they be entitled to a refund? Let's examine these issues one at a time.

STT basics

The salient features of the changes STT/LTCG tax system are as follows:

Only delivery-based transactions will continue to attract the levy of 0.15 per cent. However, this burden of the tax will be split equally between the buyer and the seller at 0.075 per cent each.

Day traders will pay a much lower rate of 0.015per cent to be adjusted against business profits. For the F&O segment, the tax will be only 1 basis point, or 0.01 per cent. All debt market deals have been completely exempted from the tax.

Equity-oriented MF schemes will come under the ambit of STT, which means buying units of mutual funds will attract a transaction tax of 0.15 per cent -- the same as equities.

Likewise, such units would be exempted from long-term capital gains tax and would attract short-term tax of 10 per cent. Units of income schemes continue under the old regime of capital gains taxation.

Resolving the questions

Let's address the most common question first: Do the above changes affect existing investments or subsequent ones?

First of all, it has to be understood that as of now, none of this is applicable. In other words, these are just proposals laid out in the Budget. Based on the inputs forwarded by the players in the industry, the government is still in the process of chopping, changing and fine-tuning the amendments.

Therefore, the new regime, as it were, will only be applicable after an announcement to that effect is made in the official gazette. The Finance Bill has not yet been converted into the Act.

Under this caveat, let's see what happens if indeed the changes, as they stand correctly get finalised. First of all, clearly STT would be applicable to only those eligible investments made on or after the announcement.

At that time, the LTCG exemption and the 10 per cent STCG tax kicks in. In other words, the LTCG/STCG changes would be applicable to securities and equity-based units purchased before, on or after the date of announcement in the official gazette but sold only on or after the date of announcement in the official gazette.

The only condition for the applicability to existing investments is that the sale should be mandatorily after the announcement date. Therefore as a corollary, any purchase and sale effected today continues to be taxed as per the old regime.

MF investors to an extent would be subject to double taxation as the fund would also pay the STT on its purchases. The LTCG exemption has no meaning in this case as anyway all income of a mutual fund is exempt u/s 10(23D).

Secondly, it looks like for unit holders the entire STT of 0.15 per cent is payable upon purchase of the units. Therefore, to that extent, the cost of the units would increase. Note that entry load, if any, would be applicable over and above this tax.

The only silver lining is that in the case of long-term gains on sale, the same would be exempt from tax. And on the other side of the coin, in the case of long-term loss, the same cannot be set-off or carried forward, it will have to be foregone.

No change for debt-based schemes

There has been no change in the taxation of dividends from MFs. Dividends from both debt and equity MFs continue to be tax-free in the hands of investors.

For individuals and HUFs, there is a distribution tax of 12.5 per cent (excluding surcharge and cess) on debt-based schemes. Equity based schemes are exempted from this distribution tax.

If you hold the units (debt-based under the new system) of any MF for more than 12 months, the same would qualify as long-term capital assets. Else, these would be termed as short-term capital assets. Upon sale, any short-term capital asset is taxed at the normal rates applicable to the assessee.

In the case of sale of MF units which are long-term capital assets capital gains tax is payable at 10 per cent without indexation or at 20 per cent with indexation.

For NRIs, the long-term capital gains are not eligible for the Rs 50,000 basic exemption threshold, income below which tax is not payable. Therefore, for any amount of long-term capital gains income, tax is payable and tax return would need to be filed.

However, the Rs 50,000 threshold is available for short-term capital gains and therefore short-term capital gains would not be taxable up to Rs 50,000, of course, assuming that the NRI has no other income in India.

If the funds are invested in growth option of MF schemes, the growth is not taxable as long as there are no withdrawals.

Day trading woes

As I have been saying throughout, the fine print has yet not come out. However, based on what's known as of now, the STT can merely be adjusted against tax on normal business income. It is not in the nature of TDS where any extra paid can be claimed back.

Else imagine the situation where a rather amateur day trader pays an STT of say Rs 50,000 but actually makes only so much profit that the tax payable works out to Rs 5,000.

In such situations, I do not think, the government would be generous enough to fork out Rs 45,000 back. Plus it would lead to all sort of "arrangements" amongst players to stay tax neutral.

Therefore, in all probability, the adjustment of STT may be limited to the tax payable on business income. Extra if any would have to be foregone.

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