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Rama Krishna Vadlamudi December 8th, 2009

Ms Roshni Nair is a young and smart lady working for a multi-


national company in their swanky office in Gurgaon drawing a
lucrative salary. She is well-educated and financially savvy
and invests her surplus in equity shares and equity mutual
funds in addition to insurance, real estate and fixed deposits.
She has started her equity investments during the stock
market hey days of 2003-2004 and continues to invest
regularly even now. Even though she churns her portfolio and
books profits regularly on her portfolio of shares and mutual
funds depending on the market conditions and her views; over
a period of time she has amassed a long-term capital gain of
around Rs 5 lakh on her equity portfolio comprising blue chip
stocks, mid-cap stocks and equity mutual funds.

Now-a-days, she is a bit concerned about her long-term


capital gains as she has read reports that she has to pay
long-term capital gains tax on stocks and mutual funds with
effect from April 1, 2011. This is as per the new Direct
Taxes Code, or DTC, placed, for discussion, in the public
domain by Government of India a few months back. To get a
better view of the tax issues involved, she sets up a
discussion with her tax consultant & the conversation follows:

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ROSHNI: “GOOD MORNING, MR SHANBAGH?”

Shanbagh: “Morning, Roshni. I’m fine…thank you.”

“I WANT TO DISCUSS WITH YOU THE IMPACT OF NEW


DTC ON MY LONG-TERM CAPITAL GAINS ON EQUITY
SHARES AND EQUITY MUTUAL FUNDS.”

“Okay, the new DTC proposes to make some sweeping changes with
regard to LTCG and STCG.”

“WHAT ARE THEY?”

“For tax treatment purposes, it proposes to abolish the distinction


between long-term capital gains tax and short-term capital gains tax
pertaining to capital gains on shares and mutual funds.”

“WHAT DOES THAT MEAN FOR MY INVESTMENTS?”

“Let me give you an example. As of now, you’re paying a short-


term capital gains tax of 15 per cent, excluding education cess of
three per cent, on your STCG and the tax on LTCG is nil for listed
equity shares as well as equity mutual funds.”

“WHAT IS THE DIFFERENCE BETWEEN LTCG AND STCG.”

“As far as shares/mutual funds are concerned, LTCG arises when


you hold them for a period of more than one year after the date of
acquisition. If you hold them for less than a year, then it will be
considered as short-term capital gain or loss as the case may be.”

“COULD YOU PLEASE EXPLAIN THE IMPLICATION?”

“Yes, let me cite a practical example. From your records, I find that
you bought 1,000 shares of Blue Star in September 2003 for a total
consideration of Rs 20,000 and sold them for Rs 340,000 in
November 2009. Here, your capital gain is Rs 320,000 (340,000-
20,000). As the shares were held for a period of more than one year,
the entire Rs 320,000 is treated as LTCG and under the existing
Income Tax Act, you need not pay any tax on this LTCG.”

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“WHAT ABOUT TAX TREATMENT OF SHORT-TERM
CAPITAL GAINS UNDER EXISTING TAX LAWS?”

“I’m coming to that. Again from your records, you bought 50


shares of Jet Airways for a total cost of Rs 13,500 in
September 2009 & sold the entire stock for Rs 27,500 in the
1st week of Dec. 2009 making a profit of Rs 14,000. As the
shares were held for less than one year, this Rs 14,000 is
considered as short-term capital gains and you have to pay a
short-capital gains tax of Rs 2,100 (15 per cent of Rs 14,000).”

“AND WHAT ABOUT THE NEW TAX PROPOSALS?”

“As per the draft code called Direct Taxes Code 2009, the
definition of LTCG and STCG remains the same for shares
and mutual funds. The only difference between the existing
and proposed system is in tax treatment of them. Under DTC,
there is no difference between STCG and LTCG. Both will be
clubbed under your taxable income and you’ve to pay tax
according to your individual tax slab.”

“PLEASE GIVE ME AN EXAMPLE.”

“In the above example cited, you do not incur any tax liability
on LTCG under the existing laws. Under the proposed system,
you’d have to add the entire Rs 320,000 LTCG made in selling
Blue Star shares to your taxable income and pay tax
according to your tax slab.”

“(COMPLETELY TAKEN ABACK!) YOU MEAN I’D HAVE TO


PAY TAX FOR THE ENTIRE Rs. 320,000?”

“Yes, Roshni, if the Government implements the DTC as given


in the draft DTC Bill, you’ve to club the entire LTCG with your
taxable income. This addition would push up your tax slab to
30 per cent, excluding education cess. On this additional
income, you’d have to pay a total tax of Rs 96,000 (30 per
cent of Rs 320,000) in addition to tax on your annual salary.”

“GOSH, THAT IS TOO MUCH, NAH?”

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“It can’t be helped. We need to follow tax rules. However,
under the proposed DTC, you could avail indexation benefit
and the tax incidence on LTCG is likely to come down if you
utilize this indexation benefit. Under the existing system,
indexation base date is April 1, 1981 and it is proposed to be
changed to April 1, 2000. However, one saving grace here is
Securities Transaction Tax (STT) charged now on all share
transactions will be abolished completely under the DTC.”
“WHAT ABOUT THE TAX TREATMENT OF STCG?”
“As has been discussed, the DTC does not distinguish LTCG
and STCG as far as tax treatment is concerned. In the above
example, you made a STCG of Rs 14,000 on sale of Jet
Airways shares. The entire Rs 14,000 will be clubbed with
your taxable income and you’ve to pay tax according to your
tax slab under DTC.”
“WHICH MEANS UNDER THE DTC, I’D HAVE TO PAY A
TOTAL TAX OF AROUND 1.5 LAKH ON MY
ACCUMULATED Rs. 5 LAKH OF LONG-TERM CAPITAL
GAINS ON SHARES/MFs?”
“That’s right provided there’re no changes in the proposed
DTC.”
“IN SUCH A CASE, SHALL I SELL ALL MY SHARES AND
BOOK PROFITS IN ORDER TO SAVE ON EXTRA AND
UNNECESSARY TAX?”
“It depends on several factors with regard to your ability to
time the markets. But, there’re no easy answers, Roshni.”

Note: In this example; brokerage, STT, education cess, service tax are ignored for simplicity.

Now, you’ve read the conversation, do you think that


investors should take out their entire long-term profit?
Market veteran and broker, Ramesh Damani opines that there would be a huge sell-off in
the Indian stock markets if the new DTC is implemented in the draft form as stated now.
However, timing the markets is fraught with danger. Mr. Ramesh Damani himself has
learnt it the hard way in the last two years. Let’s imagine a scenario. Consider you are
sitting on a long-term profit of around Rs 25 lakh and sold your entire holdings in 20
potential stocks before the implementation of DTC. This you’d done with a view to
picking up the stocks at lower prices after April 1, 2011, the effective date for DTC.

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Can we expect all the entire 20 stocks would be quoting below your selling price and you
would be able to pick all the 20 stocks at lesser prices? It’s hard to imagine that you’d be
able to be successful in all the 20 stocks.
However, this policy flip-flop from the authorities, who are supposed to promote some
stable and long-term tax policies, will cost the investors very heavily in terms of
achieving their long-term goals. This seems to be a case of Government encouraging
investors to hold shares for short-term (PURE GAMBLING?) faster churning, instead of
steady and long-term investments. The proposed DTC is also a big negative for the so-
called long-term investors in equity shares and equity mutual funds. What a tectonic
shift? All these years right from Yashwant Sinha to P Chidambaram, investors were
actively encouraged to invest for long-term purposes in order to deepen and widen capital
markets. Despite so many good developments in Indian capital markets in the last 15
years, the total savings in equities and mutual funds are at an abysmally low level of three
to four per cent nationwide. With a view to promoting capital markets, the Government
has been prodding organizations, like, EPFO and pension funds to invest a portion of
their funds in capital markets. But now, the same authorities are giving a different spin
under the proposed Direct Taxes Code.
HOW TO TWEAK YOUR INVESTMENTS GOING FORWARD IN THE LIGHT
OF THE DTC WEF APRIL 1, 2011?
Timing the market is difficult and as such, it’s not practically possible to sell the equity
shares now and acquire them after April 1, 2011. Then, what is the alternative? Shall the
long-term investors hold on to their shares where there is enormous long-term capital
gain? Or, shall they start offloading their shares before the deadline for the introduction
of new Direct Taxes Code or DTC? Obviously, there’re no easy answers.
Each individual has to take their own decision depending on their own comfort levels.
Investors, like, Warren Buffett, would not bother about such tax considerations and
would not sell their shares for the fear of paying some tax on their capital gains. But, how
many Indian investors’ pockets are as deep as that of Buffett? When everybody is selling
in the market, can you remain steadfast and hold your fort in times of turbulence? Only
time will tell. Till that time, one would love to make some wild guess that Government
would not be able to muster enough courage to implement the new Direct Taxes Code in
its present draft form.
Investors need to be aware of these provisions; otherwise, they will be completely
spooked and confused when they are introduced ultimately in 2011. Knowledge of policy
developments is vital in stock markets and other financial markets. If investors ignore
these aspects, important rules and regulations, they will be ignoring them at their own
peril.
Author’s Disclaimer: The views of the author are personal. The above shall not be
construed as tax or investment advice, though due care has been taken before writing the
above. Having said that, Investors or readers must consult their certified tax consultant
before interpreting or considering the views expressed by the author.

Rama Krishna Vadlamudi, BOMBAY www.scribd.com/vrk100 Dec. 8, 2009 Page 5 of 7


SOME ADDITIONAL READING

For my article discussing the impact of DTC concerning your investments in PPF, EPF,
NSC, insurance and other related issues, just click (this is one of my TOPMOST popular
document published by me on SCRIBD):

http://www.scribd.com/doc/19542987

UNION BUDGET 2003-04:


As per the Union Budget for 2003-04, long term capital gains (LTCG) on company
equity shares (listed on any recognized stock exchange in India) was exempted from tax
for shares acquired on or after March 1, 2003 but before March 1, 2004. This was made
applicable from April 1, 2004 and was applicable for assessment year 2004-05 and for
subsequent years. The intention of the then Government behind the tax exemption for
LTCG on listed equity shares for a limited period was to “give incentive for investment
in equity shares.”
The then finance minister, Yashwant Sinha, told the Parliament, during his budget speech
in his own words:
“We need to improve the industrial sector and improve the equity markets”
“I am also committed to bringing the small investors back to the capital markets by
restoring their confidence”
“In order to give a further fillip to the capital markets, it is proposed to exempt all long-
term capital gains from tax for equity shares bought for a period of one year from March
1, 2003, and sold after a one year…”
UNION BUDGET 2004-05:

P.Chidambaram’s, the then finance minister, spin on the rationale behind the abolition of
LTCG while presenting the Budget 2004-05 to Parliament:

“Capital gains tax is another vexed issue. When applied to capital market transactions,
the issue becomes more complex. Questions have been raised about the definitions of
long-term and short-term, and the differential tax treatment meted to the two kinds of
gains. There are no easy answers, but I have decided to make a beginning by revamping
taxes on securities transactions. Our founding fathers had wisely included entry 90 in the
Union List in the Seventh Schedule of the Constitution of India.

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“Taking a cue from that entry, I propose to abolish the tax on long-term capital gains
from securities transactions altogether. Instead, I propose to levy a small tax on
transactions in securities on stock exchanges. The rate will be 0.15 per cent of the value
of security. Thus, a transaction involving securities valued at, say, Rs.100,000 will now
bear a small tax of Rs.150. The tax will be levied on the buyer. In the case of short-term
capital gains from securities, I propose to reduce the rate of tax to a flat rate of 10 per
cent. My calculation shows that the new tax regime will be a win-win situation for all
concerned.”

This was done with a view to simplifying the tax structure on securities transactions, as
per the Explanatory Memorandum to the Union Budget 2004-05. Accordingly, tax on
LTCG was removed and tax on STCG was reduced to 10 per cent. And in the place of
‘nil tax’ on LTCG on securities transactions, a new tax called Securities Transaction Tax
(STT) was introduced by P.Chidambaram. And he is considered one of the architects of
the new Direct Taxes Code Bill 2009! What a somersault!

+++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++

THE BEST OF MY STUFF ON Reads

http://www.scribd.com/vrk100

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2. Goods and Services Tax-GST-an introduction 2 224
3. Direct Taxes Code Bill 2009-analysis 1 332
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TOTAL READS running toward 22,000!


From A Total of 66 Documents in three months

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