The Finance (No. 2) Act, 2004 brought about a sea change in the taxation of capital gains on transfer of listed shares and units of equity oriented mutual funds. In the Notes to Clauses explaining the amendments, it was stated that “With a view to simplify the tax regime on securities transactions, it is proposed to levy a tax at the rate of 0.15 per cent on the value of all the transactions of purchase of securities that take place in a recognised stock exchange in India.” Thus, the now famous Securities Transaction Tax (STT) was introduced in 2004 with effect from 1st October, 2004. Simultaneously, clause (38) was introduced in section 10 and section 111A was also newly introduced into the Statute.
Section 10(38) provided an exemption to long term capital gains on transfer of shares listed on a recognised stock exchange (BSE & NSE) provided the transaction of sale was chargeable to STT. Section 111A stated that short term capital gains on such a transfer would be taxed @ 15%.
Both the beneficial sections – 10(38) and 111A apply to all types of investors irrespective of the tax residential status and the form of entity.
Thousands of tax payers have been taking advantage of these beneficial provisions since 2004 and it is reported that crores of rupees of tax has been saved on account of the same. This concessional treatment, like all other similar treatments, gave birth to rampant tax evasion through innovative penny stock scams. The income-tax department has unearthed several such scamsters but has not been very successful in bringing to tax the bogus long term capital gains that several tax payers have enjoyed without paying tax.
Now, in the Finance Bill, 2018, this position is proposed to be changed.
In the Budget Memorandum, it is mentioned that
“Under the existing regime, long term capital gains arising from transfer of long term capital assets, being equity shares of a company or an unit of equity oriented fund or an unit of business trusts , is exempt from income-tax under clause (38) of section 10 of the Act. However, transactions in such long term capital assets carried out on a recognized stock exchange are liable to securities transaction tax (STT). Consequently, this regime is inherently biased against manufacturing and has encouraged diversion of investment in financial assets. It has also led to significant erosion in the tax base resulting in revenue loss. The problem has been further compounded by abusive use of tax arbitrage opportunities created by these exemptions.
In order to minimize economic distortions and curb erosion of tax base, it is proposed to withdraw the exemption under clause (38) of section 10 and to introduce a new section 112A in the Act to provide that long term capital gains arising from transfer of a long term capital asset being an equity share in a company or a unit of an equity oriented fund or a unit of a business trust shall be taxed at 10 per cent. of such capital gains exceeding one lakh rupees.
This amendment has been talked about loudly on all television channels all day long today and will continue to be debated for several days to go.
The salient features of the amendments proposed in this behalf are as under:
a) The exemption presently available to long term capital gains on transfer of listed equity shares and units of equity oriented mutual funds will continue for all transfers made upto 31st March, 2018. There is no change in this for the rest of the current financial year.
b) For shares already held by an investor as on 31st January, 2018, special grandfathering provisions are put in place.
c) For shares purchased on or after 1st February, 2018, there is no grandfathering available.
d) Section 10(38) is proposed to be amended to say that the exemption will not be available after 31st March, 2018.
e) A new section 112A is proposed to be introduced into the Income-tax Act, 1961 to tax the long term capital gains on the listed shares and units of equity oriented mutual funds transferred on or after 1st April, 2018.
f) For calculating the long term capital gains, special formula is proposed. In this, the cost to be taken into consideration would be as under:
For this purpose, “fair market value” means,—
(i) in a case where the capital asset is listed on any recognised stock exchange, the highest price of the capital asset quoted on such exchange on the 31st day of January, 2018:
Provided that where there is no trading in such asset on such exchange on 31st day of January, 2018, the highest price of such asset on such exchange on a date immediately preceding the 31st day of January, 2018 when such asset was traded on such exchange shall be the fair market value;
(ii) in a case where the capital asset is a unit and is not listed on a recognised stock exchange, the net asset value of such asset as on the 31st day of January, 2018;
This mechanism is explained below with a few examples:
g) It is also provided that while calculating these types of long term capital gains, indexation of cost will not be permitted. So, whatever is the actual cost, that figure has to be taken as it is (as explained above). The benefit of indexation to factor in the inflation is not available. Secondly, none of the deductions under Chapter VI-A of the Act (eg 80C, 80D, 80G etc) will also not be available for being reduced from this long term capital gain. Also, for Non Residents, the option of computing the capital gains in foreign currency and then converting to INR is also not available for this type of long term capital gains. These three deviations are primarily because the tax rate for the long term capital gains is a concessional one.
h) After the long term capital gains is calculated, the question of deciding how much tax to be paid arises.
i) It is here that unfortunately, the proposed section is worded in a confusing manner and hopefully, we will have some clarity on this in the days to come.
j) For computing tax liability, it is proposed that the long term capital gains in excess of Rs. 100,000 will be taxed at 10%. It appears that what the Finance Minister intended in his budget speech was that in such cases, it will only be the excess over Rs. 100,000 that will be taxed and therefore, logically, the first Rs. 100,000 would not be taxed. However, the actual section (112A) that is proposed is worded in a manner that gives rise to a doubt about the taxation of the first Rs. 100,000 of such type of long term capital gains. The doubt is whether such Rs. 100,000 would not be taxable at all or whether it would be included in the normal income of the investor and taxed at the applicable slab rate.
k) Another situation that may arise is that the concerned investor does not have enough income to cross the threshold limit laid down. Thus, for example, an investor may have normal taxable income of Rs. 1,10,000 and long term capital gains of Rs. 130,000. In such a case, his total income is Rs. 240,000 which is less than the threshold of Rs. 250,000. In such a case, he will not have to pay any tax. On the other other hand, if his other income is say Rs. 50,000 and he has long term capital gains of say Rs. 2,25,000. Then, his total income will be Rs. 275,000. Now, since the threshold is Rs. 250,000, he will not have to pay any tax on the normal income of Rs. 50,000 and the long term capital gains of Rs. 200,000. But on the balance Rs. 25,000 of long term capital gains, he will have to pay tax @ 10%.
The doubt that one has because of the peculiar wording of the section 112A arises because of the following wording:
“(2) The tax payable by the assessee on the total income referred to in sub-section (1) shall be the aggregate of -
(i) the amount of income-tax calculated on such long-term capital gains exceeding one lakh rupees at the rate of ten per cent.; and
(ii) the amount of income-tax payable on the balance amount of the total income as if such balance amount were the total income of the assessee:”
The confusion is on account of the use of the words “balance amount of the total income”. It seems to indicate that the first Rs. 100,000 of long term capital gains (which is carved out in the first limb of the section) has to be included in this second limb of the section. Let us see what is the actual intention of the government.
l) Another important point to be borne in mind here is that for getting this beneficial tax rate of 10% on the long term capital gains, STT will continue to be an important pre-requisite. At the time of sale of the shares / units, STT will have to be paid. But even more important is the condition that STT should also have been paid at the time of acquisition of the shares (not applicable to units of mutual funds). There is a provision that is laid down to exempt certain categories of acquisitions from this requirement of STT having to be paid. Thus, for example, in case of bonus shares or rights shares or several other legitimate modes of acquisition, it is possible that STT was not chargeable at all at the time of acquiring the shares. Such situations would be notified later.
m) Interestingly, there is no change proposed in the concessional tax treatment for short term capital gains on transfer of listed shares / units of equity oriented mutual funds. At present, these gains are taxable at 15%. This position remains untouched by the Budget 2018.
n) Another important point to be kept in mind is that generally, for long term capital gains, one can save tax by claiming exemption under section 54EC by investing in bonds issued by NHAI, REC etc. However, this exemption would also not be available for investors earning long term capital gains from transfer of listed shares and units of equity oriented mutual funds because in the Budget 2018, an amendment is proposed to section 54EC also whereby this section would apply only to long term capital gains on transfer of land or building or both. So, the long term capital gains from listed shares and units of equity oriented mutual funds would be taxable without any scope for saving taxes.
To sum up, the Budget 2018 has shaken up the capital market. Those investors who were accustomed to earning huge long term capital gains and not paying any tax would be adversely affected because they will once again have to get ready to pay tax on such gains although at a concessional rate of 10%. Fortunately, this will come into force from 1st April, 2018. Thus, there is a window available upto 31st March to dispose off the long term capital assets and earn tax free income. It remains to be seen as to how many investors will do this. If there is a stampede to do so, we will see the impact on stock prices upto 31st March.
Time will tell.