The Indian government’s decision to increase capital gains tax on listed stocks overnight by 2.5% for long-term gains and 5% for short-term gains was a brave one. Consider the context. India had been one of the best performing capital markets in the world. The Economic Survey had specifically called out challenges in sustaining overseas investor interest in a competitive global marketplace.
The call, thus, had to be taken judiciously: will an overnight rate increase cause a crisis of confidence and lead to a pullback of global funds, or will the market still view the 12.5% and 20% tax rates as fair and take this in its stride? In the event, the government was proven right.
The market fell as an immediate reaction, but then it recovered and even gave a thumbs-up by rallying smartly. The finance minister and ministry officials handled the narrative deftly, calling it a “rationalization of rates in response to industry representations.”
Having successfully managed this change, it is an opportune time to think about whether there are still any small kinks to be ironed out in the manner the law has currently been proposed. This piece argues for three changes, which stay true to the core principles that the government has enunciated in this budget and could be considered for the final version of the law.
Convertible instruments: The first relates to the treatment of convertible instruments. Under the current proposals, unlisted debentures take the character of debt and are therefore treated as short-term assets, subject to maximum marginal tax rates on transfer.
It is fair to treat debt and its returns as normal income. After all, interest income is taxed at full rates. One could legitimately say that gains on transfers of debt are no different. They ought to be taxed similarly.
A problem, however, arises where unlisted debentures are convertible. This is because globally, these instruments are used in the capital structure of entities for specific commercial purposes—such as providing senior treatment to pure equity—but in essence, the convertibility ensures that the returns profile is that of equity.
The Reserve Bank of India recognizes this principle and treats compulsorily convertible instruments as equity. The Centre’s FDI policy also accords the same treatment. Accounting norms similarly view these instruments as capital. Thus, the first tweak.
Where a debt instrument, even if unlisted, is convertible, it is essential that tax law recognizes its equity nature and places it in the same bucket as shares for taxation purposes as well.
This will be conceptually fair and allow investors, funds and corporations to continue using this instrument the way it is normally used, without having to structure it artificially merely because the tax law does not recognize the true nature of such instruments. This tweak will sharpen the distinction between debt and equity treatment and lead to the conceptually appropriate outcome.
Buyback of shares: The second conceptual change that the budget for 2024-25 has made which calls for a similar tweak relates to buybacks. The government has taken a clear call that a buyback is akin to distribution of profits and should be taxed as dividend.
This leads to the inequity that the cost of shares bought back is not immediately allowed as a direct offset, but instead becomes available as a capital loss for future set-offs against capital gains if and when they arise. I do not argue that this inequity be removed.
However, it is important to recognize that a buyback is not always a distribution of profits. Indian company law, for example, permits companies to buy back one class of shares from proceeds of another class of shares. Likewise, if the company has surplus cash because of over-capitalization, a buy-back can be a means to simply return capital.
Accordingly, the tweak this provision would need is to bring in the concept of accumulated profits while reckoning the tax treatment of buy-backs. To the extent the company has accumulated profits, it is fair that the proceeds thereof be treated and taxed as dividend.
However, if that is not the case, then the balance ought to be treated as capital gains. This would achieve the government’s objective of recognizing buybacks as distribution of profits and also align Indian tax norms with those already operating in the context of capital reduction.
Sovereign/ pension fund exemption: Today and till March 2025, a beneficial tax regime is accorded to specified investments made by notified pension and sovereign funds in India. The logic for this is that investments by this class of investors are long-term, patient and good for nation building.
In fact, contrary to tradition, even in the February vote-on-account, this exemption was extended by a year to March 2025. Extending it further would be in consonance with the broad principle behind a slight pull-back of government spending and accompanying expectations of the private investor community.
These three tweaks will further the message that this budget has laid out—one of policy consistency and outcome predictability, which are fundamental principles that investors look for while forming a view on which geographies to allocate capital to. These changes will not cause any material revenue loss to the nation, while they would encourage a virtuous investing cycle.
