Sebi's tax-neutral switch plan is good, but Indian savers still pay tax on inflated gains

Mint has published an argument by Dhirendra Kumar, founder and CEO of Value Research, that Sebi's recent budget recommendations reveal an uneven tax deal for Indian savers. The regulator has reportedly suggested removing the 12.5% long-term capital gains tax that foreign portfolio investors pay on Indian stocks, making switches between mutual fund schemes held for more than a year tax-neutral, and lowering transaction costs such as the Securities Transaction Tax. We think the tax-neutral switch proposal matters most for domestic mutual fund investors because it addresses a long-standing friction. (Source: Mint)

What happened

According to a Reuters report cited by Mint, Sebi has sent the finance ministry three budget recommendations. The first is to remove the 12.5% LTCG tax on foreign portfolio investors' Indian stock gains. The second is to treat switches between mutual fund schemes held for more than a year as tax-neutral. The third flags that transaction costs, including STT, are among the highest anywhere. Meanwhile, foreign investors have pulled out about $31 billion from India this year, while domestic savers who run SIPs and stay invested still pay 12.5% LTCG with no indexation benefit. (Source: Mint)

Our analysis

The tax-neutral switch proposal fixes a real problem. Today, moving from a poorly run fund to a better one is treated as a sale, so long-term gains are taxed even though the investor continues to stay in the market. This was not a big issue when LTCG tax on equity funds was zero, but at 12.5% it discourages investors from correcting fund choices. Kumar writes that this proposal implicitly accepts that people should not be punished for sensible long-term investing. (Source: Mint)

The bigger issue, as the column argues, is that Indian savers still pay LTCG tax on gains that may be partly inflation, because indexation has been removed. The July 2024 Budget scrapped indexation from almost everything except a partial rollback for property already bought. A lower tax rate of 12.5% applied to an inflated number can still tax illusory gains. Kumar illustrates this with numbers: if an investment grows 10% a year for a decade while inflation is 6%, LTCG tax takes 25% of real gains; if it grows 8%, the real tax rate rises to 40%; and if returns fall below about 6.5%, as the Nifty 50 has over the past three to five years, the real tax rate exceeds 100%. (Source: Mint)

This asymmetry is sharp: foreign fund managers could pay zero LTCG, while a domestic saver who has run SIPs for years still pays 12.5% on nominal gains. Lower transaction costs would help all fund investors because STT on a fund manager's trades drags down returns. If an FPI tax exemption brings foreign capital back, that may support the broader market, but our read is that the domestic saver's tax treatment remains the weak spot. (Source: Mint)

What this could mean for you

• Long-term mutual fund investors: if tax-neutral switches are adopted, moving between schemes after a year would not trigger LTCG, removing a lock-in effect that currently makes investors hesitate to leave poorly run funds.
• SIP investors: under the current rules, your accumulated equity fund gains are taxed at 12.5% without any inflation adjustment, so if returns are modest the tax may take a large share of real gains. (Source: Mint)
• Equity fund holders: any reduction in transaction costs such as STT could reduce the drag on fund returns, because these costs are paid on the fund manager's trades.
• Domestic savers: if FPIs get an LTCG exemption and you do not, the tax gap widens, though a return of foreign capital could have broad market effects.

What to watch next

• Whether the finance ministry accepts Sebi's recommendation on tax-neutral mutual fund switches in the next Union Budget, about three months away.
• Any signal that indexation will be restored or extended to equity, which the column argues would help long-term savers far more than FPI tax relief.
• Final budget changes to LTCG, STT, or transaction costs for mutual funds.

Bottom line

Our read is that tax-neutral switches are a sensible correction, but the larger unresolved issue is the absence of inflation indexation for domestic savers. If the government is willing to forgo revenue to bring foreign capital back, rethinking how it taxes patient Indian savers would be the stronger long-term move.