Long-Term Capital Gains (LTCG) Impact on the Indian Stock Market

The introduction of Long-Term Capital Gains (LTCG) tax in the 2018 Union Budget has significantly altered the landscape of the Indian stock market. This tax mandates that individuals pay a 10% levy on any gains exceeding Rs 1 lac from equity investments held for more than a year. This change has prompted a range of new trading behaviors, shifting the focus from the strategic use of bonus and split stripping to more active profit booking. The following article delves into how LTCG has affected trading activities, market volatility, and investor behavior in the Indian stock market.

Introduction of LTCG Tax

As the Indian government adopted the 10% LTCG tax on equity investments held for over a year, every investor faced the choice between tax-free future capital gains and short-term capital gains (STCG) subject to a 15% tax. The significance of this change lies in its effect on both trading activities and investor behavior. Prior to LTCG being introduced, certain strategies such as bonus and split stripping were prevalent, enabling investors to manipulate short-term gains to avoid taxes.

Strategies Utilized Before LTCG

Before the introduction of LTCG, bonus and split stripping were common tactics employed to circumvent tax obligations. For instance, a company like A, announcing a 1:1 bonus, would see its share price drop to zero for the additional shares received. Suppose an investor held one share of Company A at Rs 200 before the bonus announcement; the investor would receive one additional share, making the second share worthless. However, after the bonus, the market price of a share would drop to Rs 100. The investor could then book a loss by selling one share at Rs 100, which would allow them to avoid paying short-term capital gains tax (STCG).

Alternatively, if the investor held the share for more than a year and sold it at Rs 100, they would experience a gain of Rs 100, but since LTCG was not applicable, they would pay no tax. This tactic was particularly effective for minimizing short-term capital gains by offsetting them with equal short-term losses.

Affected Trading Activities

The introduction of LTCG has largely stopped these manipulative strategies. As a result, the Indian stock market has seen increased trading activities as investors now focus on short-term gains and book profits more frequently. This change has not only affected individual retail investors but also led to higher market volatility, as investors strive to maximize their gains within a 12-month period to minimize tax liabilities.

Behavioral Shift Among Investors

From a broader perspective, the implementation of LTCG has caused a significant shift in investor behavior. The primary takeaway is that investors are now more inclined to sell their investments after a year, regardless of market conditions. This behavior is driven by the knowledge that they will only have to pay 10% on gains exceeding Rs 1 lac, compared to the 15% tax on STCG. This shift has two key implications:

1. Narrowed Tax-Free Option

Previously, investors benefited from the STCG being taxed at 15%, and the absence of LTCG, the effective tax rate was just 5%. The emergence of LTCG has narrowed this effective tax rate to only 5%, thereby incentivizing investors to sell their profitable investments to take advantage of the lower tax rate.

2. Long-Term Profit Booking

Since the government provides an exemption on LTCG up to Rs 1 lac, investors now have an incentive to book profits in the amount of Rs 1 lac to avoid any tax liability. If this profit is unbooked, it results in a lost opportunity worth Rs 10,000. Therefore, the culture of profit booking within a year is on the rise.

Conclusion

The introduction of LTCG tax has brought significant changes to the Indian stock market by altering trading behaviors and increasing market volatility. While it has stopped manipulative strategies like bonus and split stripping, it has also motivated more frequent short-term profit booking among investors. Retail investors now have to carefully balance the trade-offs between tax-free future gains and shorter-term gains subject to a 5% tax rate. Long-term holding periods are becoming less favorable as the opportunity cost of waiting is higher due to the effective tax benefits of booking profits within a year.

This shift highlights the dynamic nature of tax laws and their profound impact on market dynamics and investor behavior in the Indian stock market.