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Turnover tax and you

Jul 13, 2004

Budget 2004-05 and its proposals have largely gone down well with most people. However, the fact remains that there were, are and will always be certain issues, which would face opposition from various factions of the industry/society in every budget. This time around, one issue that has clearly stood out and overshadowed other budget proposals is the turnover tax issue (securities transaction tax as put by the Finance Minister (FM)). It must be noted that on the Budget day, as soon as the FM announced the levying of the 0.15% transaction tax, Indian stock markets cracked by 150 points (intra-day). It was only after certain clarifications that were made by market watchdog, Securities and Exchange Board of India (SEBI), that markets staged a sharp comeback the following day. So, what is this turnover tax all about? Why has it been levied and what is the impact of this on retail investors?

The turnover tax, in simple terms, is basically a certain amount of tax to be paid by the buyer of a security. The amount, as mentioned earlier, is 0.15% of the transaction value (shares in quantity x price per share). The purpose of this tax is to partially counter the loss of revenues from the government's proposed reduction of short-term capital gains tax (STCG) to 10% and exempting long-term capital gains (LTCG) from the taxation purview, among others. By proposing the two capital gains taxation measures, the FM has tried to bring our country at par with many other economies where largely similar taxation policies apply, an example being the much-touted Mauritius. Further, by making LTCG tax-free, it is an attraction for the massive US pension funds, which get similar treatment in their home country. Also, this (no LTCG tax) would (probably) lead to investors taking a longer-term view towards equities, thus insulating themselves from the day-to-day stock market volatility, which more often than not puts their capital at risk.

With the turnover tax being seemingly a good move by the FM, there is already a lot of criticism surrounding the proposal. While the FM has indicated that there are numerous examples of the success of the turnover tax, people opposing the same have managed to throw around examples of countries (like Japan) where the turnover tax has actually been a dampener for the stock markets. In the Indian context, amongst the various arguments supporting the anti-turnover tax lobby is the fact that the imposition of the turnover tax will have an adverse impact of the liquidity (volumes) in the equity markets. The long-term investors are going to be the biggest beneficiaries of this new regime and hence logically only the traders or arbitrageurs are complaining. This is owing to the fact that over 3/4th of the daily volume on the Indian stock exchanges is accounted for by day traders and arbitrageurs, who operate on nominal margins. Thus, the implementation of this tax would kill their very incentive to trade, which would consequently be reflected in the stock markets volumes dwindling.

However, at this juncture, while we need to remember similar arguments, with respect to volumes, were brought forward at the time of doing away with the 'Badla' system and reducing the settlement period to T+2 system, what has been observed over time is that the markets tend to comfortably adapt to the changed environment.

Further, another important issue to be considered here is what needs to be given priority, speculation (which would get affected by the turnover tax) or cultivating 'investment' type behaviour in our markets (as is indicated by lower tax on capital gains). Also, it must be noted that while the FM has accepted reconsideration of the turnover tax, provided the anti-turnover tax lobby comes with alternative solution to generating similar revenues from capital markets. However, there needs to be a debate on whether the current or the proposed structure will be best suited for both the government as well as the investors. In this article let us take a look at possible scenarios as to how investors would be affected by the new regime.

Achieving a break-even…
Current Proposed
Buy Sell Buy Sell
Transaction value (Rs) 10,000 10,109 10,000 10,127
Brokerage @ 0.5% 50 51 50 51
Proposed turnover tax @ 0.15% - - 15 -
Service Tax (@ 8% and 10%) 4.0 4.0 5.0 5.1
Proposed cess @ 2% - - 0.4 0.1
Total transaction cost (Rs) 54.0 54.6 70.4 55.8
Gross short-term capital gains 109   127  
(Less) Both sides transaction costs 109   126  
Net short-term capital gains 0   1  
Short-term capital gains tax 30%   10%  
Net gains to investor (Rs) 0.3   0.7  

The above table shows the current and the proposed structure of a stock market trade and what level of gross returns (excluding all costs) would lead to the investor achieving break-even. As can be seen above, in the current structure, with brokerage assumed at 0.5% of the transaction value (each side) and service tax @ 8% (each side), the total transaction (buying and selling) costs comes to Rs 109 (rounded off). Thus, in order to recover his costs and achieve break-even, the investor needs to sell his holdings at atleast 1.1% higher price than the purchase price.

However, in the proposed structure, with the additional service tax (@ 10%), education cess (@ 2%) and the turnover tax (@ 0.15% of transaction value), in order to achieve break-even, the investor needs to sell his securities at atleast 1.3% over his acquisition price. Thus considering this, an investor is clearly at a disadvantage in the new structure. Note: In both the cases above, the break-even points would vary depending on the brokerage costs.

Relative gains…
Current Proposed
Buy Sell Buy Sell
Transaction value (Rs) 10,000 10,188 10,000 10,188
Brokerage @ 0.5% 50 51 50 51
Proposed turnover tax @ 0.15% - - 15 -
Service Tax (@ 8% and 10%) 4.0 4.1 5.0 5.1
Proposed cess @ 2% - - 0.4 0.1
Total transaction cost (Rs) 54.0 55.0 70.4 56.1
Gross short-term capital gains 188   188  
(Less) Both sides transaction costs 109   127  
Net short-term capital gains 79   61  
Short-term capital gains tax 30%   10%  
Net gains to investor (Rs) 55.3   55.3  

However, the above is a very micro scenario considering that an investor will be just wanting to recover his costs, which is definitely not the actual case. Assuming that India is a growth story and an investor holds his investments for a relatively longer period of time (but less than one-year), the turnover tax picture turns favourable, giving the FM the upper hand.

As can be seen in the table above, when the relative gains in the two structures are compared (all previous assumptions remaining constant), an investor would earn similar net gains (after factoring in the costs under both the structures) if he books his profits at a 1.9% higher price than his acquisition cost. But this is just one-half of the story.

The 'big' plus point here is when gains are over 2% (at the gross level). Just to put things in perspective, for a moment, let us assume that the gross returns for an investor are 5%. In this situation, while his net gains (after meeting all expenses) would be 2.7% (on transaction value) in the current scenario, the same would be higher at 3.3% in the proposed scenario (thanks to the reduction in STCG tax to 10%). Further, if the gross returns were 10% higher, the net gains would improve from 6.2% to 7.8%! This is the 'big' plus point that we were talking about in the proposed structure. While we have only highlighted short-term scenarios, looking at the same we can conclude that for long-term investors (holding period of over one year) the benefits would be even larger due to no LTCG tax.

Thus, to conclude, while we agree that there are various arguments against the implementation of this tax like stock market volumes getting affected, additional cost burden (irrespective of the investor making profits/losses on his investment) and the day traders, jobbers and arbitrageurs getting affected, the larger picture seemingly appears to be more lucrative. Remember, while the FM has agreed to reduce the turnover tax (if other alternatives are provided), it needs to be remembered that the alternative way out could be detrimental to the larger interest of investors.

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