Who says our taxmen don’t have a sense of humour? Look no further than Budget 2018. Impish tax babus made sure equity investors in the country will remember their grandfathers — fondly and for a long time to come.
They did this by slipping in the ‘grandfathering’ clause along with the key change that had grown-up market-men and women bawling — the imposition of 10 per cent tax on long-term capital gains (LTCG) above ₹1 lakh on listed equity shares and equity mutual funds. The ‘grandfathering’ softened the tax blow and pacified the wailing considerably. The taxman was tough and kind at the same time — quite a feat, really.
So, what is the LTCG tax on equity all about and how does grandfather play Santa? The all-knowing taxman, aware of the confusion and panic caused by the Budget on February 1, came up with a list of frequently asked questions (FAQ) on February 4. Tapping into this comprehensive FAQ list, among other sources, here’s an explainer on the why, when and how of the tax.
Why
Currently, long-term capital gains on listed equity shares and equity mutual funds are exempt from tax. That is, if you sell these shares and mutual fund units after holding them for more than 12 months from the date of acquisition, the gains are considered long-term and no tax is levied on them. Also, gains on equity and equity mutual funds held for 12 months or less (short-term gains) are taxed at a concessional rate of 15 per cent.
This preferential tax treatment has been around for a long time now — since 2004, when the securities transaction tax (STT) was introduced in tandem with the concessional tax treatment on equity investments.
But all good things must come to an end. Voices to end the preferential tax treatment for equity were getting louder. “Why should equity instruments be given tax exemption, when debt instruments such as bank fixed deposits do not get any?” the argument went. Especially given that returns on equity have been very healthy over the past few years, quite unlike that on debt instruments.
The government let the ball pass last year but went for the catch in this year’s Budget, ignoring pleas and veiled threats by market players. The FAQ says that the exemption has led to significant erosion in the tax base, resulting in revenue loss, with the problem further compounded by abusive use of tax arbitrage opportunities.
So, Budget 2018 has proposed that LTCG arising from transfer of such equity shares and equity mutual funds exceeding ₹1 lakh will be taxed at 10 per cent. The tax exemption on gains up to ₹1 lakh seeks to shield small investors and bring into the net investors with large gains.
When
The tax kicks in from fiscal 2018-19. That is, it will be levied on LTCG arising from transfer of the equity investment on or after April 1, 2018. So, if you sell these investments until March 31, 2018 and make LTCG, such gains will continue to be exempt from tax. This window for tax-free gains contributed to the selling pressure in the market after the Budget.
How
The first step is to compute the LTCG. This is done by deducting the cost of acquisition from the full value of consideration on transfer of the long-term capital asset, says the FAQ. Simply put, gain on investment is its selling price minus cost.
Here’s where ‘grandfathering’ becomes important. All LTCG up to January 31, 2018 will be grandfathered, that is, they will continue to be exempt from tax. This applies irrespective of when the investment was made and how much it has appreciated until the cut-off date. Only LTCG made after January 31, 2018 will be taxed.
This significant concession is thanks to the formula for determining the cost of acquisition: Higher of a) actual cost b) lower of i) fair market value on January 31, 2018 ii) selling price. The value on January 31, 2018 is the highest intra-day traded price for listed equity shares, and net asset value (NAV) of mutual funds on that day.
The formula does two things. One, it allows the benefit of exempting from tax the LTCG made up to January 31, 2018. Two, it does not allow long-term capital loss and (consequently lower tax) in cases where the selling price is lower than the value as on January 31, 2018 but higher than the original cost price.
Once the LTCG is determined, gains in excess of ₹1 lakh will taxed at 10 per cent. Surcharge on tax, if applicable, and cess on tax plus surcharge at 4 per cent will also apply, as usual. Indexation of cost of acquisition, that factors inflation over the holding period of the investment, is not allowed in the case of LTCG tax on equity. Indexation of cost results in taxation of only real inflation-adjusted gains. This also leaves open the prospect of long-term capital loss in the future, if inflation runs high.
The lack of indexation benefit is a drawback for equity investors, but on the positive side, the rate of tax at 10 per cent is still much lower than the 20 per cent tax rate (with indexation) applicable to LTCG on many other asset classes such as gold, real estate and debt mutual funds. Also, STT continues despite the introduction of tax on LTCG on equity. This seems unfair, since STT was originally introduced as compensation for concessional tax treatment on equity. But the powers-that-be argue that tax rates are still concessional for equity – 15 per cent on short-term gains and 10 per cent on long-term gains, much lower than in many other asset classes.
Some examples
The somewhat complicated concept of cost of acquisition and resultant LTCG is best explained with the scenarios below in the FAQ and reproduced below:
Scenario 1 – An equity share is acquired on January 1, 2017 at ₹100, its fair market value is ₹200 on January 31, 2018 and it is sold on April 1, 2018 at ₹250.
As the actual cost of acquisition is less than the fair market value as on January 31, the fair market value of ₹200 will be taken as the cost of acquisition and the long-term capital gain will be ₹50 (₹250 – ₹200).
Scenario 2 – An equity share is acquired on January 1, 2017 at ₹100, its fair market value is ₹200 on January 31, 2018 and it is sold on April 1 at ₹150.
In this case, the actual cost of acquisition is less than the fair market value as on January 31. However, the sale value is also less than the fair market value as on January 31. Accordingly, the sale value of ₹150 will be taken as the cost of acquisition and the long-term capital gain will be nil (₹150 – ₹150). [ Note that there is no capital loss (₹150 - ₹200) allowed in this transaction merely because the sale price is lower than the fair market value on January 31.]
Scenario 3 – An equity share is acquired on January 1, 2017 at ₹100, its fair market value is ₹50 on January 31, 2018 and it is sold on April 1 at ₹150.
In this case, the fair market value as on January 31, 2018 is less than the actual cost of acquisition, and therefore, the actual cost of ₹100 will be taken as actual cost of acquisition and the long-term capital gain will be ₹50 (₹150 – ₹100).
Scenario 4 – An equity share is acquired on January 1, 2017 at ₹100, its fair market value is ₹200 on January 31, 2018 and it is sold on April 1, 2018 at ₹50.
In this case, the actual cost of acquisition is less than the fair market value as on January 31, 2018. The sale value is less than the fair market value as on January 31, 2018 and also the actual cost of acquisition. Therefore, the actual cost of ₹100 will be taken as the cost of acquisition in this case. Hence, the long-term capital loss will be ₹50 (₹50 – ₹100) in] this case. [ Note that capital loss is allowed on this transaction since the sale price is lower than the actual cost of acquisition. ]
To sum, the long-term capital gains exceeding ₹1 lakh arising from transfer of listed equity shares and equity mutual funds made on after April 1, 2018 will be taxed at 10 per cent. However, there will be no tax on gains accrued up to January 31, 2018.
Other points
There will be no tax deduction at source (TDS) on such LTCG and the investor is responsible for paying the tax. Also, since there is no tax on LTCG until March 31, 2018, there is also no provision for set-off of long-term capital loss on equity incurred until March 31, 2018. Long-term capital loss arising from sale made after April 1, 2018 will be allowed to be set off and carried forward as per the tax rules.