Trading | Surge in STT may increase the cost of doing business in India

The STT hike may force the FPIs to reduce or revisit their India allocations, due to higher cost of transacting in India

In a surprise move, the Government of India hiked the Securities Transaction Tax (STT) payable on the sale of futures and options transactions (F&O transactions) by nearly 25 per cent, from 0.01 per cent to 0.0125 per cent in the case of Futures, and from 0.05 per cent to 0.0625 per cent in the case of Options, starting April 1. The change and the timing of this move caught traders, investors and securities market intermediaries in the F&O market off-guard, especially at a time when the stock markets have been volatile owing to the prevailing global environment.

While the government has not provided any specific reason for bringing about this change, it is believed that the rationale could be two-fold:

To promote financial discipline; and dissuade speculative trading and volatility in the F&O segment by individual traders, who, according to SEBI’s January 23 report have been incurring losses.

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To increase tax collections: With rising trends in F&O volumes, an increase in the STT can be seen as a silent masterstroke by the government to increase its tax kitty without any increase in income-tax rates.

While the aforesaid objectives are noted, the STT hike could act as a deterrent to genuine market participants in the F&O segment, especially participants in the Futures market (where the STT is payable on the actual traded price as against Options where the STT is paid on premium). The STT hike will have a greater impact on High-Frequency Traders (HFTs) and algo-traders, given the large transaction volumes in which they deal. The change will now require such players to relook at their trading strategies, causing unwarranted, and temporary, business disruptions.

The STT hike could also have a bearing on foreign portfolio investors, who deal in Indian securities derivatives. Unfortunately, the taxation regime in India for the FPIs and Indian tax resident investors on income arising on F&O trades fails to provide respite or offset the STT hike in any manner:

In the context of FPIs, though they trade frequently in F&O and at a higher volume, due to a deeming friction in the income-tax laws, income earned by the FPIs from F&O transactions is deemed to be capital gains. Such capital gains get categorised as Short-Term Capital Gains (STCGs) given the tenor of these contracts, and attract a tax rate of 30 per cent (to be increased by applicable surcharge and cess), with no ability to claim an income-tax deduction for the STT paid while computing their taxable capital gains. Hence, the entire increase in the STT will become a sunk cost for the FPIs. This would equally apply to Indian tax resident investors (not traders!) in F&O transactions.

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The taxing regime is different for Indian tax resident traders, who trade significant volumes with the intention of earning profits in F&O trades as a part of their regular business activities. This is because the income arising to them by trading in F&O trades is taxed as business profits and they are permitted to claim a tax deduction for the STT paid. Hence, to that extent, the impact of the STT hike will be slightly lower for Indian tax resident traders.

The FPIs incurring capital losses on transactions in F&O trades (and offering income to tax under the Indian domestic tax laws) will not be able to offset the increased STT payments against their other capital gains income.

Overall, one will need to wait and watch how market participants react to this change over the next 3 to 6 months as the F&O trade volumes could decline in the short-term, till the High-Frequency Traders (HFTs) and traders reconfigure their investment strategies. This will increase their cost of doing business in India and also have a bearing on the expected tax collection targets of the government.

Moreover, in times, when the FPIs have been bullish on the Indian markets, the STT hike may force the FPIs to reduce or revisit their India allocations, due to the higher cost of transacting in India, which may not be beneficial to the Indian economy in the long-run.

(Russell Gaitonde is Partner, and Fojan Furniturewala is Director, Deloitte India.)

Disclaimer: The views expressed above are the author's own. They do not necessarily reflect the views of DH.