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Tax laws must match Indians' new savings architecture

The taxation structure of long-term capital gains encourages bad investment practices

Tax laws must match Indians' new savings architecture

Indian saver and investors are well on their way to building a brand new saving architecture. As I've written earlier in these pages, we now have a large--Rs 8,000+ crore a month--SIP inflow from individual investors into equity mutual funds. This flow of fresh investments is extremely stable and along with NPS and EPFO inflows, they are now the backbone of the Indian equity markets.

However, while the investor is now moving into this new world of productive, long-term, inflation-beating wealth creation, our laws on capital gains taxation are stuck in the old paradigm. Capital gains taxation on equity in India is structured in a way that is built more for the anti-rich rhetoric of the seventies than for a growth economy. Moreover, it actively works against investors optimising their returns and choosing the highest degree of wealth creation.

At the heart of this problem is what the tax law considers to be a transaction in which capital gains are created. In mutual fund investing, every time an investor sells units of a fund, the gains that he makes are considered to be capital gains under the tax laws. If the period of holding is less than a year, then these are short-term capital gains, if more than one year then these are long-term capital gains. In equity funds, long-term capital gains were zero till 2018, having been abolished in 2005.

The nature of this is such that effectively penalises long-term investments, which is exactly the opposite behaviour from what should be the case. Over a long period of investment--say several years or even decades--there is often a point when an investor realises that the money is invested in a mutual fund to which there better alternatives have become available. At this point, if the investor sells the investments in one fund and invests the proceeds in another fund, he becomes liable for capital gains tax on the gains made in the previous fund. This either reduces returns, or forces savers to balance off tax liabilities with potentially lower returns, and leads to suboptimal choices. To enable savers to leverage their investments to the fullest extent, switching from one equity mutual fund to another should not be considered to be a transaction.

This demand has been around for a long time and is in fact part of the demands that the Association of Mutual Fund of India (AMFI) has put forth before the finance minister. Before 2018, this point was a moot one as the tax on long-term capital gains was zero. However, what is being talked about here is different from zero tax. Here, what I'm saying is that eventually, when the investment is redeemed for consuming the money, let there be tax. However, merely switching from one long-term investment to another should not attract tax.

The interesting thing is that roughly such a provision is already there in the tax laws. Section 54 has a longstanding provision that long-term capital gains from can be tax free if deployed into another a residential house within a short time period. However, the strange thing is that it considers nothing but a residential house to be the asset type into which the money should be deployed. Under section 54, you can use the proceeds from the sale of a long-term investment to buy one house and not have to worry about tax as long as the house you buy is also held for more than three years. This privilege is not available for any other type of investment.

This may have made sense in earlier times when a house was the only true long-term investment that most people managed to make and large financial investments were rare. However, that's not what real savers' personal finance is like any more. Whether it's done in this budget or later, a provision like Section 54 has become a must for other classes of savings and assets that Indians are making.