Capital Gains Tax Changes And You

The hike in Long-Term Capital Gains Tax and the removal of indexation benefits from property, hybrid mutual funds and gold have raised worries about higher tax burdens for investors. Yet, the market’s current trajectory suggests an underlying confidence and resilience that is baffling many analysts. This article explains the reason for such divergence between market performance and the expected negative impact of the budget’s tax changes 
 

In a surprising turn of events, the Indian equity market has displayed remarkable resilience, seemingly unfazed by the recent changes in the Union Budget. Despite an unexpected election outcome and a budget that disappointed many market participants, the frontline indices have been on a winning streak. As of the week ending July 26, 2024, the Sensex has experienced its longest weekly winning streak since January 2021, while Nifty 50 has seen its best performance since January 2018. 
 

Weekly Chart of Nifty 

This performance comes amid concerns over increased tax liabilities stemming from the budget’s new provisions. The hike in Long-Term Capital Gains Tax and the removal of indexation benefits from property, hybrid mutual funds and gold have raised worries about higher tax burdens for investors. Yet, the market’s current trajectory suggests an underlying confidence and resilience that is baffling many analysts. In the following paragraphs, we will try to understand and explain the reason for such divergence between market performance and the expected negative impact of the budget’s tax changes. 
 

Long-Term Capital Gain 

The recent Union Budget has introduced significant changes to the tax rates affecting various investment instruments, reshaping the financial landscape for taxpayers. One of the most impactful changes is the hike in Long-Term Capital Gains (LTCG) Tax rates, now set at a flat 12.5 per cent across most categories, including equities. Previously, LTCG on equities was taxed at 10 per cent after a 12-month holding period. This has now increased to 12.5 per cent for the same duration. 



 

Additionally, the exemption limit has been raised from ₹1 lakh to ₹1.25 lakhs. This means investors will now only be liable for LTCG Tax if their gains exceed ₹1.25 lakhs. This change benefits those booking profits below ₹2.25 lakhs, making ₹2.25 lakhs the new inflection point—beyond which the new tax rate exceeds the previous one. To illustrate, consider the following: Under the new tax regime, there is no tax liability for gains up to ₹1.25 lakhs. However, once profits surpass ₹2.25 lakhs, the tax liability increases compared to the previous tax rates. 
 

Impact on Investors 

To assess the impact on investors, we performed a back-of-theenvelope calculation based on the annualised rate of return expected from equity investments. Using historical data, the Sensex has delivered an annualised return of approximately 15 per cent since its inception in 1979. Adjusting for exceptional returns in recent years, a conservative estimate of 12 per cent annual return from equities is reasonable. With a 12 per cent return, an investor can earn up to ₹1.25 lakhs in profits on an investment of just over ₹10 lakhs without incurring any LTCG Tax. For instance, if an investor invests ₹1,041,667 and earns a 12 per cent return, the profit would be around ₹1.25 lakhs, which falls within the exempted limit. 
 

Thus, investors can book profits on investments up to ₹10 lakhs annually without attracting any LTCG Tax under the new tax structure. This adjustment provides a tax-efficient strategy for retail investors managing their investment portfolios within this threshold. This becomes even more important because LTCG is applicable on long-term gains, which, for most people are investments to achieve life goals such as children’s marriage or retirement. Depending upon the level of income, the investment corpuses for these can often run into crores, especially in case of retirement. 
 

The following example will help you understand the new tax better: You have invested ₹50 lakhs in equity funds in 2024. By 2054 i.e. 30 years later, your funds are collectively valued at ₹15 crore, assuming a 12 per cent annualised return. 

Formula to calculate LTCG tax:
(Gains – Exemption amount) × Rate of tax

Calculation of gains: Calculation of gains: 
Gains = Redemption amount − Investment amount 
Gains = ₹15,00,00,000 − ₹50,00,000 =₹14,50,00,000 

Case 1 (LTCG @10%; Exemption – ₹1 lakh):

Summary of new tax burden: 

Case 1: 
LTCG @ 10% 
Exemption: ₹1 lakh 
Tax: ₹1,44,90,000 

Case 2: 
LTCG @ 12.5% 
Exemption: ₹1.25 lakh 
Tax: ₹1,81,09,375
 

You can see the difference that with a 10 per cent LTCG tax rate and a ₹1 lakh exemption, the tax liability would be ₹14,490,000. However, under the new tax regime with a 12.5 per cent LTCG Tax rate and an ₹1.25 lakhs exemption, the tax liability increases to ₹18,109,375. This demonstrates a significant impact on one’s savings, as the new tax structure results in an additional tax burden of ₹3,619,375, highlighting the importance of understanding and planning for tax changes in long-term investments. 
 

Now, let us suppose that you book profit of ₹10 lakhs every year and reinvest, assuming there are no leakages in terms of brokerage commission or difference in the price at which you book profit and at which you re-enter. In that case, you need to pay LTCG of ₹15,731,206, which is still above what you would have been paying earlier. Nonetheless, it is much better than if you would have not actively booked profits. The worst case is for someone who is approaching retirement. He may find a deficit in his retirement corpus to the extent to which he has to pay tax. He cannot use even tax harvesting to lower his tax burden. 
 

An investor investing in equity-dedicated mutual funds will also get the same treatment. Hence, an investor can combine both direct equity and equity-dedicated mutual funds to get this exemption. Thus, it is prudent for an investor to keep booking profits up to ₹10 lakhs on equity investments including mutual funds. An investor can easily do tax harvesting and save tax. Listed bonds and debentures too will incur the same treatment as listed equities. In addition to equities, there are other securities where we see a change in LTCG. 
 

Though these are not as widespread like equity, they still form part of many investors’ holdings and hence assume importance. LTCG on Real Estate Investment Trusts and Infrastructure Investment Trusts will see an increase in LTCG from 10 per cent to 12.50 per cent. Nevertheless, the adjusted holding periods has been reduced from 36 to 12 months. Earlier, one would require holding these assets for at least three years before he could avail LTCG. For unlisted equities, now the LTCG has been reduced to 12.5 per cent from the earlier 20 per cent. Nonetheless, now the indexation benefit has been taken away. 
 

Lowering of this LTCG Tax on unlisted equities in India will benefit a range of stakeholders including angel investors, venture capitalists, private equity funds and start-up employees with ESOPs by reducing their tax burden and increasing the net returns. Founders and early-stage investors will also gain from higher retained earnings, while SMEs will find improved access to capital. This change can stimulate increased activity in the private equity market, enhance liquidity, and support broader economic growth by fostering more investment and innovation in private companies. 


Short-Term Capital Gain 

Along with LTCG, the tax rate on Short-Term Capital Gains (STCG) has also been revised for most of the asset classes and securities. For equity-oriented funds, including aggressive hybrid and balanced advantage funds with equity having more than 65 per cent of holdings, as well as listed stocks, the STCG rate has been increased from 15 per cent to 20 per cent. This change will impact investors who typically engage in short-term trading, as their gains will now be taxed at a higher rate, reducing the net returns from such investments. 
 

Let us consider a hypothetical example to understand the impact of the revised STCG Tax on an investor’s returns. Suppose an investor initially invests ₹100,000 and makes a gain of ₹20,000 within a year. Before the tax revision, the STCG Tax rate was 15 per cent, resulting in a tax of ₹3,000 on the gain of ₹20,000. Therefore, the net gain after tax would be ₹17,000. However, with the revised STCG Tax rate increased to 20 per cent, the tax on the same ₹20,000 gain would now be ₹4,000, reducing the net gain to ₹16,000. 
 

This change leads to an additional tax burden of ₹1,000 for the investor, and now the post tax gain reduces from 17 per cent to 16 per cent. This shows how the increase in the STCG Tax rate from 15 per cent to 20 per cent reduces the net returns from short-term investments. Similarly, the STCG rate for Real Estate Investment Trusts and Infrastructure Investment Trusts has also been raised from 15 per cent to 20 per cent, aligning these investments with the new rate for equity and equity-oriented funds. Post this announcement we have seen a fall in the prices of listed REITs before making a recovery. The same has happened with most of the real estate companies. 
 

After the first kneejerk reaction, these securities are once again gaining price momentum. While the recent Union Budget offers a tax exemption opportunity for long-term capital gains, it provides no such relief for short-term gains. Investors will now face an additional tax of ₹5,200 for every ₹1 lakh earned in short-term gains. This increase is not necessarily negative. It aims to make short-term trading and speculation less attractive, thereby discouraging punters and day traders. The rationale behind increasing the Short-Term Capital Gains Tax is multifaceted. 
 

Many investors engage in short-term trading, and a significant portion of them incur losses. A study by the Securities and Exchange Board of India found that over 70 per cent of individual investors involved in intraday trading experienced an average loss of ₹5,371 during the financial year 2022-23. The study encompassed nearly 7 million investors trading in the equity cash segment. By taxing short-term gains more heavily, the government likely aims to discourage excessive speculation, promote longer-term investments, and ultimately stabilise the markets. 
 

Additionally, such tax hikes align domestic tax practices with global standards, further integrating India into the global financial system. The impact on overall trading is significant. Higher taxes render short-term trading less profitable, potentially reducing speculative activities. As a result, investors may shift their focus towards long-term investments to benefit from lower Long-Term Capital Gains Tax rates and the exemption limit, fostering a more stable investment environment. 
 

However, this shift could also affect market liquidity, as fewer daily transactions occur. Investors and fund managers will need to adjust their strategies, potentially considering the higher impact costs associated with decreased liquidity. Despite these challenges, the extent of liquidity changes will depend on how well investors adapt to these new tax regulations. Historical parallels in the Indian equity market provide insights into the potential effects of such tax changes. During the 1991 economic reforms, the Indian government made several tax modifications, including changes to Capital Gains Tax, to attract foreign investments and stabilise the market. 
 

Following the changes, the market gained for a year or so after which we saw the Harshad Mehta scam. Post that the market remained range-bound for almost seven to eight years. We believe it had more to do with the economic condition than the tax changes. The reintroduction of LTCG Tax in 2018, after a 14-year hiatus, led to short-term market volatility as investors adjusted to the new tax regime. Similarly, changes in the dividend Distribution Tax (DDT) proposed in the Union Budget 2020 did not impact investor sentiment or influence the overall trading behaviour and portfolio adjustments. 
 

Conclusion

The recent changes in the taxation of capital gains, as outlined in the Finance (No. 2) Bill, 2024, aim to simplify and rationalise the tax structure, making it more straightforward for taxpayers to comply with. The new provisions reduce the complexity of holding periods, now limiting them to just one year for listed securities and two years for other assets. This streamlining will help reduce confusion and ease the computation of taxes. Additionally, the tax rates have been made more uniform, with the elimination of indexation in favour of a lower flat rate of 12.5 per cent, which simplifies calculations and ensures consistency. 
 

The parity established between resident and non-resident taxpayers further promotes fairness and equity in the tax system. Moreover, the retention of roll-over benefits encourages continued investment and offers a means for taxpayers to defer Capital Gains Tax under certain conditions, especially in case of sale of property. Overall, these changes aim to enhance compliance, reduce administrative burdens, and create a more transparent and equitable taxation framework. In the overall scheme of things, increasing the limit of exemption of capital gains on certain financial assets from ₹1 lakh to ₹1.25 lakhs per year will definitely spin benefits for the lower and middleincome classes.