The market’s worst fear came true on Thursday. The Budget has proposed to tax long-term capital gains exceeding ₹1 lakh from the transfer of listed equity shares, units of equity-oriented funds at a rate of 10 per cent.

Though the markets turned nervous immediately after this announcement, the benchmark indices clawed back from the day’s lows. Also, to promote the trades in stock exchanges located in the International Financial Services Centre (IFSC), the capital gains on derivatives and certain securities transacted by non-residents have been exempt from tax. Additionally, the Alternative Minimum Tax (AMT) for non-corporates in IFSC has been fixed at a concessional rate of 9 per cent. This could boost transactions in the IFSC at the GIFT City that is beginning to see traction in recent months.

The introduction of long-term capital gains tax in equities is not going to have a major impact on the foreign portfolio investors’ flow into the Indian equity market.

The background

India has been one of the much sought after emerging market destinations for FPIs. Data from the National Securities Depository Limited (NSDL) is clear evidence for this. Data available for the last 16 years (since 2002), indicates that in only two years, FPIs were net sellers in the Indian equity segment. In 2008, they sold around $12 billion and in 2011 $0.36 billion. On similar lines, after buying about $7.6 billion in equities in 2017, the flows in 2018 have also begun on a strong note with FPIs having pumped in $2.2 billion in January.

Three major factors make India more attractive for the FPIs. Firstly, the Indian economy is considered more stable compared to many of its peers. Secondly, the volatility in the Indian currency is relatively less (and consequently the currency is more stable) compared to other emerging market currencies. This makes the return on investment more attractive for the FPIs. Thirdly, the Indian benchmark indices have given relatively better returns over the last few years. In four out of the last six years, Indian equities have given the best return (year-on-year).

Impact

Allowing the gains made until January 31, 2018, to be completely exempt from capital gains tax could be a catch since the markets are currently at record highs. FPIs may want to lock-in some profit to enjoy the benefits of grandfathering. But this could be a short-term phenomenon and will not stop the FPIs from investing in Indian equities. Also, according to sources, while markets such as Singapore and Hong Kong do not tax the capital gains from equities, others such as Brazil (15 to 22 per cent), China (25 per cent), and South Africa (22 per cent) do levy this tax. Given this and with India taxing the gains exceeding ₹1 lakh only, FPI flows are unlikely to lose momentum.

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