Long-term capital gains (LTCG) arising from the transfer of a long-term capital asset are either taxed at a concessional rate in India or exempt from taxation on meeting some preconditions.
By TV Mohandas Pai & S Krishnan
It was recently reported in the media that there are anomalies in the processing of I-T returns at the IT department’s Central Processing Centre, resulting in incorrect computation of tax liability on capital gains. It’s not surprising, since taxation of capital gains is one of the most complex regimes to understand.
Holding periods are different for various types of assets. Tax rates are different for short-term and long-term gains, and are different for various assets.
Exemptions are provided on meeting some preconditions and withdrawal of those exemptions when the preconditions are not met. In addition, some specified categories of long-term capital assets get the benefit of cost-inflation indexation, whereby the base cost of the asset is increased by the ratio of inflation in the year of sale and purchase. The rules for carry-forward and set-off are also not uniform. Short-term capital loss, which is carried forward from earlier years, can be adjusted against long-term capital gains as well as short-term capital gains, whereas long-term capital loss can be adjusted only against long-term capital gains!
Long-term capital gains (LTCG) arising from the transfer of a long-term capital asset are either taxed at a concessional rate in India or exempt from taxation on meeting some preconditions. A long-term capital asset is defined by the period of holding such capital asset. The de facto holding period for a long-term capital asset in India is more than 36 months immediately preceding the date of its transfer. However, this de facto period is modified for various types of assets. In the case of a share listed on a recognised stock exchange in India, the holding period is 12 months, while it is 24 months in the case of an unlisted share. The holding period in case of a debenture listed on a recognised stock exchange in India is 12 months, while it is 36 months for unlisted debentures. In the case of an equity-oriented mutual fund unit, the holding period is 12 months, while it is 36 months for a debt-oriented mutual fund unit. An immovable property being land or building or both is considered long-term if the holding period is 24 months.
The capital gains tax rate is different for short-term and long-term assets, depending on the type of capital asset and payment of applicable securities transaction tax (STT). The accompanying table provides a summary of the tax rates and the tenure to determine long-term capital asset.
The LTCG exemption regime is further complicated with too many rules and restrictions, and is not uniformly applicable for all taxpayers. An individual or a HUF generating LTCG on transfer/sale of an existing residential house property is exempt to the extent the LTCG is used to buy or construct maximum of two new houses (residential property). However, LTCG on the sale of existing house property must not exceed `2 crore. The new properties must be purchased either one year before the sale or two years after the sale of the property. Or the new residential properties must be constructed within three years of the sale of the property. If the taxpayer is not able to use the capital gains to buy or construct new houses before the date of furnishing of the return of income, he or she should deposit the amount in the Capital Gains Accounts Scheme (CGAS), else the gains become taxable. This benefit can be claimed only once in the lifetime by an individual or a member of HUF. If full amount of LTCG is not reinvested, then pro rata relief is available.
LTCG arising on transfer of any capital asset not being a residential house is exempt from taxation if the taxpayer, being an individual or a HUF, has within a period of one year before or two years after the transfer date purchased, or within a period of three years after that date constructed one residential house in India. If full amount of LTCG is not used for the purchase or construction, then pro rata relief is available. The taxpayer will not be entitled to LTCG exemption if he or she (1) owns more than one residential house, other than the new asset, on the date of transfer of the original asset; or (2) purchases any residential house, other than the new asset, within a period of one year after the date of transfer of the original asset; or (3) constructs any residential house, other than the new asset, within a period of three years after the date of transfer of the original asset.
If a taxpayer within six months from the sale of land or building or both (residential or non-residential) has invested LTCG in long-term specified bonds issued by NHAI and REC or by the central government for a minimum period of five years, such LTCG shall be tax exempt to a maximum of Rs 50 lakh. This exemption is available to any person. All of these are confusing to ordinary taxpayers, forcing them to seek professional help.
The finance minister, earlier this year, simplified the corporate tax regime by introducing two low-tax rates associated with no deductions and exemptions. A similar approach should be adopted for capital gains tax regime. An exclusive capital gains tax regime should be introduced for financial assets, whereby investments in equity and debt securities, whether listed or not, should be taxed in a uniform manner.
Various types of financial assets carry risks associated with returns. Defaults in interest payment of debt securities in India in the recent past indicate that debt securities also carry significant risk. There is no rationale for debt securities to be considered as long-term capital assets after a holding period of 36 months, instead of 12 months applicable for listed equity securities and equity mutual fund units. It is similar for the difference in tax rates. To take benefit of lower tax rates of equity securities, many investors opt to invest in arbitrage funds/hybrid funds, with the justification that the risk is similar to a debt fund and its taxation is similar to an equity fund, thereby possibly generating higher post-tax returns.
Investments in unlisted equity shares carry higher risks compared to listed equity shares. However, the holding period is 24 months for unlisted shares to qualify as a long-term capital asset and the tax rate is higher at 20% with indexation benefit. There is no rationale for this difference.
To rectify this anomaly, all investments in financial assets should be considered as long-term capital assets after 12 months of holding. Income-tax rate of 10% with an exemption up to `1 lakh should be extended to LTCG from all financial assets. Income-tax rate of 15% should be applicable for short-term capital gains from all financial assets. To incentivise investments in start-up companies, a tax deduction of 50% should be provided in the year of investment. Consequently, investments in listed and unlisted equity shares and debentures, and equity and debt mutual fund units, would be taxed in a similar manner. This will enable investors to choose investments based on risk and reward suitable to them, rather than driven by tax considerations.
Immovable property, being land or building, is considered long-term capital asset if held for a period of more than 24 months. LTCG from transfer of immovable property is subject to taxation at 20% with indexation benefits. The option of taxation at a lower rate of 10% without indexation benefit should also be extended to immovable property, which would then be similar to the rate applicable to financial assets. The lower tax rate of 10% would make the real estate sector attractive for investments, thereby helping real estate builders to reduce the volume of unsold inventory. A simple capital gains tax regime will help investors in compliance and the income-tax department in administration.
Pai is chairman, Aarin Capital Partners, and Krishnan is a tax consultant