Computing capital gains tax demystified

Investors are often bewildered by computation of Capital Gains Tax. Whether you invest in stocks, bonds, mutual funds, real estate, or any other financial instrument, you need to know the impact of the capital gains tax on your return. In this article we try to demystify Capital Gains specially for investments in equities.

A capital gain is income derived from the sale of an investment. The difference between cost price and sale price of the capital asset held by an investor is capital gain. Depending on the time period of holding, the gains are classified as short term or long term gains. The tax incidence is higher in the case of short term capital gain as compared to long term capital gain.

Capital Gains

The most common capital gains are realized from the sale of stocks, bonds, precious metals and property. Equities are considered long term capital if the holding period is one year or more. Long term capital gains from equities are not taxed if shares are sold through recognized stock exchange and Securities Transaction Tax (STT) is paid on the sale . However short term capital gain from equities held for less than one year, is taxed at 15% plus surcharge and education cess as per provisions laid down in Budget 2008-09. This is applicable only for transactions that attract Securities Transaction Tax (STT).

Many other capital investments (house, buildings, real estate, etc) are considered long term if the holding period is three or more years. Short term capital gains are taxed just as any other income and they can be negated against short term capital loss from the same business.

The tax on long term capital gain (on sale of securities not attracting STT) can be computed under option 1 or option 2, whichever is lower, subject to the following conditions:

1. The taxpayer is an individual, HUF, company or any other person
2. The asset is a long term asset
3. The long term capital asset is a security listed in any recognized stock exchange in India

Computation Of Capital Gains Tax

Method of computation of short term and long term capital gain is given in the table below:

Short term Capital Gain	Long term Capital Gain (Sec 112)
	Option 1	Option 2
1. Find out the full value of consideration	Find out the sale value consideration	Find out the sale value consideration
Deduct : Expenditure Incurred, Cost of Acquisition, Cost of Improvement	Deduct Indexed Cost of Acquisition/ Improvement / expenses on transfer	Deduct Cost of Acquisition / / Improvement / expenses on transfer
Balance taxable under personal rates of tax.	20% of the balance amount is the tax liability	10% of the balance amount is the tax liability

 

Full value of consideration

The consideration for the transfer of shares is what the transferor receives in lieu of shares, namely, money or money’s worth. Where shares or warrants are allotted by the company to its employees under Employees’ Stock Option Plan (ESOP) and such shares are transferred by the employees by way of gift, the market value on the date of such transfer shall be deemed to be the full value of the consideration received as a result of transfer.

Expenditure Incurred on Transfer

Expenditure incurred wholly and exclusively in connection with the transfer of a capital asset is deductible from full value of consideration. Examples of such expenses are brokerage or commission paid, cost of stamp and registration fee etc.

Cost of Acquisition

Cost of acquisition of a share is the value for which it was acquired. Capital expenses incurred for acquiring the title to the shares are included in the cost of acquisition.

Indexed Cost of Acquisition

Starting with FY 81-82 as the base year, the RBI notifies the Cost Inflation Index (CII) every year. Indexed Cost of Acquisition is arrived at by multiplying the cost of Acquisition with the ratio of CII for the year of sale and year of purchase respectively. Indexation essentially adjusts cost for inflation thereby reducing the amount of capital gains.

Capital Gains and Bonus shares

In the case of bonus shares, the date of acquisition is taken as the date of their issue for capital gain classification and not the date of acquisition of the original shares. Section 55 of Income Tax Act has been amended with effect from the assessment year 1996-97 so as to specify that the cost of acquisition of any additional financial asset as bonus shares or security or otherwise which is received without any payment on the basis of his holding any financial asset shall be taken to be nil

Capital Gains and Rights shares

Income Tax Act prescribes broad provisions on computation of income under the head Capital Gains. There was no specific provision dealing with the determination of the cost of financial instruments like right shares, rights entitlement. Courts have laid down certain methods for determining the cost.

1. The cost of rights entitlement in the hands of original shareholders is deemed to be nil. The amount realized by the original shareholder by selling his rights entitlement will be short term capital gains in his hands. The period of holding the rights entitlement will be reckoned from the date of offer made by the company to the date of renouncement.
2. The cost of the rights share acquired by the original shareholder is the price actually paid by him to the company for the right share.
3. The cost of the rights in the hands of the investor is equal to the cost incurred by him for purchasing the rights entitlement Plus the price paid by him to the company for acquiring the rights shares.

Conclusion

If an investor has held the shares (both equity and preference shares) for not more than 12months, profits realized on sale will be treated as short term gains and will be taxed as per personal tax slabs. Long term capital gains on securities where STT is paid is nil.

The capital gains tax is different from almost all other forms of taxation in that it is a voluntary tax. Since the tax is paid only when an asset is sold, taxpayers can legally avoid payment by holding on to their assets–a phenomenon known as the “lock-in effect”.