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Capital gains tax made easy! - Views on News from Equitymaster
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  • Sep 9, 1999

    Capital gains tax made easy!

    The Indian Income Tax Act is arguably the most complicated piece of law ever written. After several requests by our loyal visitors, we have tried to unravel one aspect of it - the calculation of tax on long term capitals on stocks and securities.

    Long term capital gains tax play a major role in determining the levels of investment flows into the capital markets. This is so because they have a direct bearing on the post tax yields of such investments.

    Budget brings relief
    The erstwhile finance minister, Yashwant Sinha, had proposed a much-wanted concession during the presentation of the Annual Budget (FY2000). After a brief speech the finance minister announced that he was proposing the reduction of the long-term (refers to a holding period exceeding 12 months) capital gains tax on shares and securities to a universal 10 per cent. This removed the long existing discrepancy in the tax laws, under which non-resident Indians (NRIs) were charged a lower rate of tax on long term capital gains as compared to the Indian investor. Undoubtedly, the move invited a lot of praise. However, this was not to last for long.

    The Finance Minister, in his budget speech, had very conveniently avoided mentioning that the lower long capital gains tax rate was applicable only if some other tax saving benefit was forgone. The benefit to be forgone was cost indexation.

    What is indexation?
    Indexation typically means bringing the purchase cost of an asset to current values. To put it simply, it informs the owner what is the cost of his asset at today's prices. The index, published by the government takes into account factors like inflation, which are primarily responsible for eroding the value of an asset over the holding period.

    Indian tax laws provide an opportunity to an individual to index the cost of the asset over the period of holding for calculating the tax payable on sale of the asset. Over a longer period of holding, this could prove to be a major tax saving device.


    How should we index the cost of the asset?
    To explain this, let us consider that a person has purchased 1 share of Telco at a net rate of Rs 400 per share in 1994. The formula for indexing the cost of these shares is:

    Indexed cost of acquisition = Cost of acquisition X (Current cost index/cost index in the year of purchase)

    So the indexed cost of 1 share of Telco at Rs 400 (in 1994) = 400 X (351/244) = Rs 575.4 per share

    Therefore, if the stock were to be sold at, say, Rs 650, then the long term capital gains from the sale of these shares will be Rs 74.6 (Rs 650 - Rs 575.4) as against on Rs 250 (Rs 650 - 400).

    This is so because his cost, for the purpose of calculating tax, is now Rs 575.4 per share. This long term capital gains will attract tax at the prevailing rates.

    Taxpayers now have two options...
    After the proposed amendment, a resident Indian now has two options while calculating his long-term capital gains tax (for assessment year 2001).

    Option 1: Index the cost of acquisition
    Under the first option, he continues to calculate tax the way he has been doing till now.

    1. Find out the sale consideration
    2. Deduct the indexed cost of acquisition
    3. Balancing amount is the long term capital gains
    4. Tax liability is 20 per cent (+10 per cent surcharge) of the balance, translating into an effective tax rate of 22 per cent.

    Option 2: Lower tax rate, but...
    The second option that has now been made available to the Indian investor:

    1. Find out the sale consideration
    2. Deduct the original cost of acquisition
    3. Balancing amount is the long term capital gains
    4. Tax liability is 10 per cent (+10 per cent surcharge) of the balance, translating into an effective tax rate of 11 percent.

    Continuing with the same example, the tax liability under the two options will be as under:

    Option I
    1. Sale consideration:Rs 650
    2. Indexed cost of purchase:Rs 575.4
    3. Capital gains (for the purpose of tax):Rs 74.6 (1-2)
    4. Tax (22 per cent of Rs 74.6):Rs 16.4 per share

    Option II
    Sale Consideration:Rs 650
    Cost of purchase:Rs 400
    Capital gains (for the purpose of tax):Rs 250 (1-2)
    Tax (11 per cent of Rs 250):Rs 27.5 per share

    In this example, the taxpayer benefits by adopting Option I as against Option II. However, in another situation, calculations may throw up different results.

    No free lunches!
    Let us assume that the same investor was awarded bonus shares in Telco in the ratio of 1 share for every share held. The investor would receive 100 bonus shares, which if sold (after a period of 12 months) could be taxed as follows:

    Option I
    Sale consideration:Rs 650
    Indexed cost of purchase:Rs 0*
    Capital gains (for the purpose of tax):Rs 650 (1-2)
    Tax (22 per cent of Rs 650):Rs 143 per share

    Option II
    Sale Consideration:Rs 650
    Cost of purchase:Rs 0*
    Capital gains (for the purpose of tax):Rs 650 (1-2)
    Tax (11 per cent of Rs 650):Rs 71.5 per share
    * According to law, the cost of bonus shares, for the purpose of computing the
    long term capital gains, is to be taken as nil.

    In this case, Option II is a better alternative for the investor. Therefore, we see that in different situations the investor might prefer to use a different option.

    Please note:
    1. Long term or short term capital loss can be set off against any capital gain (whether long term or short term);
    2. Losses under the head 'Capital Gains' cannot be set off against income under other heads of income.

    Conditions that have to be satisfied to be eligible for either of the two options:

    1. The taxpayer is an individual, Hindu undivided family, company or any other person (maybe resident or non resident)
    2. The asset is a long term capital asset
    3. It is a 'security' as defined under section 2 (h) of the Securities Contracts (Regulation) Act, 1956. As per section 2 (h) 'securities' include - (1) shares, scrips, stocks, bonds, debentures, debenture stock or other marketable securities of a like nature in or of any incorporated company or other body corporate; (2) Government securities; (3) such other instruments as may be declared by the central government to be securities; and (4) rights or interest in securities.
    4. Such security is listed in any recognised stock exchange in India.



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