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The government’s fiscal programme for the coming year will affect investors, residents and non-residents alike. With proposed changes affecting levies on dividends, income from mutual funds, share buybacks, sovereign gold bonds and futures and options, the government is decisively revamping its policies. Long-term investments will be rewarded and economic realities recognised. Investors must therefore review their portfolios and investment strategies as soon as possible.

The taxation of share buybacks has been variously based on capital gains, a specific head and dividend income. It will now revert to being treated as capital gains. Under present provisions, distributions on buybacks are taxed as dividends on a gross basis. The cost of acquiring the shares bought back is now recognised as a capital loss. The reclassification will result in a lower effective tax rate on buyback proceeds. This results not only from a lower tax rate applying to long-term capital gains, but also because such a tax is levied on the net proceeds. These will be the distributed proceeds less the costs of those shares.

Promoter tax targets share buybacks

However, the government proposes to counterbalance these measures by imposing an additional tax on promoters and significant shareholders to maintain revenue neutrality. The effective rate for promoters, in the case of shares held as long-term capital assets, will be 22% for domestic companies and set at 30% in other cases. When shares are held as short-term capital assets, promoters will be liable to pay an additional levy of 2% in the case of a domestic company and 10% in all other cases.

Although this proposal will bring significant relief to small shareholders, the additional tax on promoters and significant shareholders is a countermeasure to the greater control that promoters have over buyback decisions. It will also deter promoters from structuring such transactions to their advantage.

Tax reforms hit leveraged investors

Passive incomes such as dividends and income from mutual funds are usually taxed as income from other sources. Taxpayers may claim a capped deduction for the interest cost incurred in earning such income. This has made leveraged positions in high yielding investments very attractive. However, the finance minister, in a move to close such an inviting concession, has proposed to end in its entirety the deduction allowed for expenditure incurred in earning dividend and mutual fund income. Thus, leveraged investors are now likely to face higher tax burdens. This may warrant an urgent reassessment of their debt financed investments. Companies and funds relying on such leveraged investors for their capital may be affected because returns on investment will be reduced. This reform suggests that India is looking to position itself as a responsible tax jurisdiction by reducing opportunities for leverage-driven speculation.

Capital gains arising from the redemption of sovereign gold bonds (SGBs) are currently exempt from taxation in the hands of individual investors. The government proposes restricting this exemption to the original subscribers of these bonds. Investors acquiring such bonds on the secondary market will no longer benefit. This ensures that only genuine long-term savers will enjoy the exemption, not short-term speculators. However, it may inadvertently disadvantage genuine investors who purchased SGBs in good faith, expecting to benefit from such exemptions.

Although this change will reduce the appeal of the secondary SGB market, the amendment returns the investment to its original purpose of channelling household savings into formal financial instruments and reducing imports of gold.

Higher derivatives tax curbs speculation

In a move designed to reduce the disproportionate rise of speculation in futures and options trading, the administration proposes to increase the securities transaction tax on derivatives trading. The tax on options premiums will go from 0.1% to 0.15%, that on exercised options will rise from 0.125% to 0.15% and the levy on futures contracts will increase from 0.02% to 0.05%. Although modest, these hikes may significantly affect high-frequency and speculative traders.

These changes represent a well-thought-out move to rationalise the investment culture in India, closing loopholes and discouraging speculation. Investors should therefore urgently analyse their existing investment structures and strategies.

Kunal Savani is a partner and Bipluv Jhingan is a principal associate at Cyril Amarchand Mangaldas