A clean-up is needed in India’s tax regime to make it rational across assets. There is also a need for policy permanence
Opinions on taxes on assets almost always depend on one’s position in life. Those without assets see the merit in taxing the asset-rich and those who have built or inherited assets will argue for no or low taxes. After all, they argue, that tax on the income has already been paid and then the assets have been created — why tax them again? But other than a few tax havens that have zero tax on income or profit from assets, most nations tax both income and profits from assets. As does India. The tax regime in India has been used to nudge investors in certain directions and has ended up in a thoughtless hotchpotch with no first principles in sight. Worse, the lack of policy predictability leaves investors angry and confused as they are unable to make long-term decisions with their money. I argue for a first-principles-based approach to taxing both income and profits from assets for a nation that is on the road to middle-income status.
But first, let me define the broad categories into which assets fall. These are equity (stocks and equity funds), debt (fixed deposits, public provident fund, bonds, debt funds) and real assets that will include real estate (immovable) and gold (movable), among other things. Income from assets is usually taxed at the slab rate (the maximum tax rate that your income tax is levied — also called your marginal rate of taxation). So, income from debt is interest and from real estate is rent. Equity, like gold, throws off no income, though, in India, dividends (that are actually distributed profits) are taxed as income in the investor’s hands. Profit, or loss, is the difference between the buy price and the sell price. Called “capital gains”, these are taxed according to the length of time they are held by the investor. If held for a shorter period of time, these profits are taxed mostly as income. For a longer holding tenure, the long-term capital gains are usually taxed at a lower rate. Sometimes these profits are adjusted for inflation, lowering the tax burden. Then there is the issue of re-investment — should the government tax profits from an asset at all if it is getting reinvested in the same asset class? All these lead to very different treatments for the three asset classes.
I suggest that all assets have a rationalisation of treatment across three parameters. Treat them equally so that investors can make investment decisions based on the merit of the asset rather than to harvest a lower tax regime.
The first parameter is that there should be equality regarding rates of taxation. For the same purpose (income or capital gain), tax rates must be equalised across the three asset classes and the various forms they are held in, removing the tax arbitrage that exists today. I would like to argue for reducing the rates to the lowest possible rather than the other way around. The exact number is for the budget team to decide — this column is more a strategy direction than a recommendation on rates.
Second, there should be equality regarding the holding period to classify an asset as held for the short-term or the long-term. Equity (and listed bonds) go long-term after a holding period of one year, real estate at two years, physical gold at three years, and gold and debt mutual funds do not go long-term at all. In a strange move in 2023, the ministry of finance classified long-term profits on debt mutual funds as income to be taxed at the investor’s marginal tax rate, while listed bonds get treated as equity in terms of their long-term tax treatment. This move defies logic, and better sense must prevail when the full audit of the taxes on assets is done. A neat tax system should equalise the holding period that classifies an asset as short-term or long-term and should not differentiate the mode of holding the asset — directly or through an institution.
Third, there should be equality regarding reinvestment treatment. The current system gives a free pass to real estate by making profits tax-free if reinvested in specific bonds or another piece of real estate. There are many conditions and these keep changing year to year. But the basic tax pass that is given to real estate is not given to any other asset class for reinvestment within the same asset class. This is particularly worrisome for long-term equity investors who cannot switch from a poorly performing fund to a well-performing fund because there is a capital gains tax on exit. Surely there can be a way to switch your holding, say within a month, into another fund for no incidence of a long-term capital gains tax.
Two more issues need attention. One, we need policy permanence and not this annual tinkering with the tax system. It is difficult to make long-term decisions for investors if the ground beneath your feet keeps changing. Why is it so difficult to think through the tax on assets on a first principles basis and then just stick to it?
And last, please clean up the strange rule of taxing equity as debt when it comes to fund of funds in the mutual fund space. With ₹20,000 crore of systematic investment plans coming month after month from retail investors into risk assets such as equity funds, mutual funds are now the go-to product for middle India seeking a long-term investment product. However, a special category of funds called fund of funds which is just a mutual fund that buys units of other funds — typically used to invest overseas to give geographical divarication to a portfolio — has a tax rule that is incorrect. There is no other way to put it — it is just wrong to tax an equity fund of funds as debt.
As the government likes to say, India is on its way to becoming a developed country. Amrit Kaal by 2047 is a realisable goal. Along with prosperity will come financialisation and the need for investments. We still have time before the rush of retail money becomes a gush. We should sort out our asset tax system fast and give a clear pathway to an aspiring India that wants to be rich.