The need to rethink capital gains tax 

When dealing with capital gains, taxpayers often find themselves entangled in a web of complexities of tax regime and multitude of provisions to consider. The current structure, a byproduct of fragmented policy considerations, has evolved into a complicated system with multiple layers, which presents a series of challenges that merit reconsideration in light of the current economic environment.

The tax law classifies the capital gains arising from sale of a capital asset as long-term capital gains (LTCG) or short-term capital gains (STCG) based on the period for which the asset was held by the taxpayer. The need to ascertain whether the capital gains arising from such sale are long-term or short-term arises because there are different tax rates for the two.

Current capital gains tax structure inconsistently defines holding periods for different assets within the same class — a key example being financial assets. Listed securities are long-term if held over 12 months, while unlisted shares require over 24 months, and other unlisted securities need more than 36 months. Market-linked debentures are an exception, with gains always treated as short-term regardless of the holding period.

In addition to the inconsistencies in period of holding criteria, the current tax structure provides for different tax rates for different assets within same class for Indian residents, as can be seen in the accompanying table that captures a broad overview of capital gains tax provisions in summary form and therefore intended for general guidance only.

This inconsistency can lead to confusion among investors, as they attempt to discern the tax implications of their portfolio decisions. While the intention behind varying rates and periods may be to encourage certain types of investment or to address specific economic goals, the result is often a lack of clarity that complicates financial planning. To rationalise this, the government may consider having a uniform holding period criteria for assets across each class of assets and applicable tax rates.

Another area that needs reconsideration is inconsistent availability of benefit of indexation. The application of indexation benefits, which adjusts the purchase cost of long-term assets for inflation, lacks uniformity, affecting the calculation of real taxable gains.

Presently, there is inconsistency as to the availability of this benefit across different assets. To illustrate, benefit of indexation is available in case of LTCG derived from sale of unlisted shares, but such benefit is not available in case of listed shares. To offset this, listed shares are taxed at a lower rate of 10 per cent (with an exemption up to ₹1 lakh), while unlisted shares, which benefit from indexation, are taxed at 20 per cent. This inconsistency results in varied tax outcomes for similar investments, leading to uncertainty for taxpayers.

To align the tax treatments between different classes, indexation benefit may not be needed for long-term capital gains on sale of financial assets if the tax rates and holding period across all assets under this class are aligned.

The current tax law’s restriction on using long-term capital losses to offset only long-term gains, not short-term gains, is another point of contention for taxpayers. This means tax benefits for long-term losses are deferred until long-term gains are made. Should there be a rehaul of the current capital gains structure, the government may permit long-term losses to offset short-term gains.

The varying tax rates for residents and non-residents introduce additional complexity to the tax system. Although these differences align with global tax practices and can be rationalised by fiscal policies, they require advanced knowledge and compliance, potentially deterring investors and complicating matters around taxability of consequent exit.

In summary, capital gains tax reform is necessary to address the current system’s inconsistencies and complexities. Simplifying holding periods, harmonising tax rates, and allowing flexibility around loss set-offs can make the tax regime fairer and more efficient. These changes would aid financial planning, encourage investment, and boost economic growth. It’s vital for the revenue to pursue a streamlined capital gains tax structure that adapts to the economy’s changing demands.

The writer is Tax Partner, EY India