2 Share Market Tax Reforms applicable from 1st April

Two major tax reforms were recently implemented in India, which are expected to have an influence on derivative markets and investment patterns.

First, in the case of debt-oriented mutual funds, investors could previously benefit from long-term capital gains tax treatment on gains realized from the sale of units held in such mutual funds for a period of more than three years. The government has provided that any gains realized on the sale of units of a debt-oriented mutual fund (where the equity portion does not exceed 35%) will now be taxed as short-term capital gains (regardless of the holding period of such units), i.e., at the applicable marginal rate (similar to ordinary income).

As a result, long-term capital gains that were previously taxed at 20% with indexation benefits can now be taxed at 30%, providing a little tax-based incentive to invest in long-term debt funds. Notably, the loss of long-term capital gains tax treatment will apply to gold, international equity, and even equity fund of funds (FoFs) that invest in other mutual fund schemes and/or foreign stocks.

It is claimed that the government planned to bring tax parity between returns from debt-oriented mutual funds and other investment instruments such as fixed deposits and other fixed income products with regard to debt funds. The essential premise is that taxes should not have a distorting effect on the decision to invest in fixed income products rather than debt-based mutual funds. Furthermore, it may be symptomatic of policy perceptions that any return on debt has the trappings of interest and so ordinary income (rather than capital gains).

Second, the securities transaction tax (STT), which is levied on on-market sales of securities, was raised for futures and options (F&O) in the following ways. The STT rate has been raised from 0.05 percent to 0.0625 percent for transactions involving the sale of options in securities (where the option is not exercised). The STT rate for transactions involving the selling of futures in securities has been raised from 0.01 percent to 0.0125 percent. Higher transaction costs will be passed on to market participants, particularly traders, speculators, hedgers, and arbitrageurs.

Furthermore, trading volumes in F&O may shift from futures to options because STT is paid only on the premium amount in the case of options rather than the total contract value in the case of futures.

The modification of STT rates comes at a time when the number of demat accounts in India has crossed the 100 million mark. In a recent report, SEBI stated that total participation in the equities F&O market increased by more than 500% in FY22 compared to FY19. Surprisingly, 89% of these individual traders lost money in FY22. The hike in STT rates looks to kill two birds with one stone: it prevents the average retail investor from entering the F&O market, where the vast majority of them lose money, while also increasing revenue collection from F&O trading.

It also appears that the government’s objective is to encourage long-term delivery-based investing in order to increase market stability.

It will be fascinating to see how the Indian investor’s investment patterns have changed as a result of the big changes brought about by the Finance Act of 2023 relating to securities transaction tax and mutual fund taxation.