The Hindu Business Line : Dissecting the capital gains tax proposals

While the Direct Taxes Code aims to simplify the capital gains taxation regime, the overall tax incidence on assessees may be higher due to the removal of preferred status granted under the Act.

Girish Vanvari
Alok Mundra

The Direct Taxes Code (DTC) has proposed to simplify the existing capital gains provisions to make them more contemporary and concise. Some of the key changes in capital gains taxation are as follows.

Investment assets

To begin with, the term ‘capital asset’ attracting capital gain taxation has been replaced with the term ‘investment asset’. Thus, the scope of capital gains is restricted to only investment assets which would not include business asset such as self-generated assets, right to manufacture and other capital asset connected with the business.

Accordingly, transfer of business capital assets will be taxed under the head ‘business income’ and not ‘capital gains’. Currently, under the Act income arising on disposal of intangibles and sale of business is taxed as capital gains, which in the DTC would be taxed as ‘income arising from business’.

The DTC proposes to remove the distinction between short-term and long-term capital gains on all classes of assets, taxing any gains on transfer of capital assets at normal rates of tax.

To illustrate, capital gains on transfer of any long-term capital asset (that is, asset held for more than three years) is currently taxed at 20 per cent. The DTC proposes to tax the similar asset at the normal tax rate of 30 per cent for individuals in the higher tax bracket and 25 per cent for companies.

This is a significant shift from the preferred tax treatment given on transfer of capital assets vis-À-vis business income. This may help in reducing the perennial litigation surrounding the taxability of income on disposal of particular capital asset as ‘business income’ or ‘capital gains’ as the end liability may not be materially different under both the heads in the DTC.

Nonetheless the higher tax on capital gains may make it rigid for large corporate houses to reshuffle the structures on an ongoing basis to adopt the contemporary corporate or tax efficient structures. For example, block deals of shares between promoter group companies to facilitate a particular group structure may result in taxable gain for the transferor.

Abolishment of STT

The Securities Transaction Tax (STT) levied while buying and selling of shares and securities over the stock exchanges is proposed to be abolished.

Currently, capital gains on sale of shares and securities have been accorded preferential treatment to encourage investment in the equity market. There is no long-term capital gains tax on shares bought or sold through the stock exchanges and only STT is payable on such transactions and shares held for more than one year are considered as long-term for tax purposes.

In this context, it would be pertinent to note that in the DTC, the classification as long-term and short-term capital assets and different period of holding (shares or other capital assets) to determine such classification has been removed. As a consequence the capital gains arising on such stock market transfers would now attract capital gains tax.

Indexation benefit

Further, the DTC has clarified that the benefit of indexation will be available to all classes of taxpayers, including non-residents, in respect of all assets (other than ‘business assets’ as they are no longer in the domain of ‘capital gains’) which are sold after one year from the end of the financial year in which such assets were purchased. This seems to end the controversy on the availability of such benefit to non-residents on the divestment of listed securities. This benefit is extended to all the classes of investment assets and the practice of providing this benefit on the basis of classification of assessees and nature of investment as provided under the Act is to be done away with.

Change of base year

The base year is proposed to be changed from April 1, 1981 to April 1, 2000. Accordingly, the taxpayer is given an option to choose either the purchase price of the asset or the fair market value of the asset as on April 1, 2000, in case of assets purchased prior to April 1, 2000. This should ease out the problems faced by assessees in getting the data as of April 1, 1981 in the case of inherited assets.

Trigger point for timing of transfer

In the past years, transfer of capital assets for the purpose of taxability as capital gains used to be a matter of contention between the Tax Department and assessees and used to result in prolonged litigation. In order to bring about better clarity, the DTC provides for certain circumstances for which timing of transfer is pre-defined to avoid litigations. It goes to add a residual scenario, wherein if particular transfer of asset does not fall within any defined transaction, transfer for such a transaction would be treated as taxable in the financial year in which the transfer took place which is similar to the language deployed in Section 45 of the Act.

Treatment when cost of acquisition is indeterminate

Under the Act, in some situation the disposal of capital assets was not charged to tax on the ground that the cost of acquisition of capital asset is indeterminate and therefore computation mechanism provided under Section 48 fails. The DTC has rather simplified this issue wherein it is provided that where the investment asset is self-generated or the cost of acquisition to person or previous owner is incapable of being determined, the cost of acquisition/improvement on such transactions will be considered as “NIL’. This has negated many landmark judgments of Supreme Court of India (CIT vs B C Srinivasa Setty (128 ITR 294), CIT vs Mugneeram Banger & Co (57 ITR 299), PNB Finance Ltd vs CIT (164 TAXATION 539) which have commented on the failure of computation mechanism.

Rollover relief

Moving further, the ‘rollover’ relief i.e. exemption of capital gains for reinvestment of the sale consideration or capital gains in specified modes will be limited to the following circumstances: (a) transfer of agriculture land and reinvestment of sale proceeds into one or more pieces of agricultural land; (b) transfer of any investment asset and reinvestment in any residential house or capital gains savings scheme. It would be interesting to note that exemption for reinvestment in a residential house would be available only if the assessee at the time of transfer of investment assets does not own any residential house, unlike the existing provisions wherein a new residential house acquired one year prior to the disposal of capital assets other than the residential house was also considered for the purpose of exemption. Another interesting aspect of the DTC is that outer time limit for reinvestment is provided for investment in capital gains savings scheme; however no such outer limit has been provided for reinvestment in agricultural land or residential house. A peculiar situation may arise wherein the assessee may dispose of investment asset but may not receive the consideration before 60 days; in that situation, the assessee cannot enjoy the benefit of investing in capital gains saving scheme to avail himself of the exemption.

Crry forward of capital loss

Though some of the exemption or preferred tax treatment on sale of capital gains have been removed, the DTC has brought in equitable change by allowing the carry forward of unabsorbed capital losses indefinitely. However, one has to file the return of income within the prescribed time limits. In case the return of income for any year is not filed within the due date, the entire brought forward loss shall not be allowed to be carried forward, irrespective of the fact that the return of income for the year in which loss was incurred was filed within the due date. Though this appears to be harsh, this probably aims at streamlining tax compliances by the assessees within the prescribed time limit. In addition, the loss incurred under the head ‘income from capital gains’ is not allowed to be set off against income from any other source.

Slump sale as business income

Profit on sale of an undertaking under “slump sale” will no longer be treated as capital gains. Such profits shall form part of income from business. It would be noteworthy that the definition of slump sale is tightened. As per the DTC, only sale of an undertaking is covered within the definition of slump sale, sale of part of undertaking or assets and liabilities which constitute business activities may no longer qualify to be a slump sale.

Removal of some exemptions

Unlike the existing provisions of the Act, the DTC does not the capital gains arising on transfer on account of conversion of partnership firm, limited liability partnership firm or sole proprietorship into a company. Nonetheless, the definition of amalgamation has been widened to include the amalgamation of unincorporated bodies into a company which includes sole proprietorship firm (partnership firm /limited liability partnership). Therefore plain conversion of the above concerns into a company may result in capital gains tax or tax on business income depending on nature of assets comprised in these concerns.

Further, transfer of capital assets in the transaction of reverse mortgage is exempt under the existing provisions of the Act. The DTC does not provide for similar exemption.

Lock-in requirement

Under the existing provisions of the Act, if a capital asset is transferred from a holding company to its wholly-owned subsidiary or vice versa, it was considered as exempt transfer, subject to ‘holding - wholly owned subsidiary’ relationship continuing for a period of 8 years from the date of transfer and capital assets not being is not converted into stock-in-trade of its business till the expiry of 8 years. The DTC also provides for similar exemption; however it has not provided for lock-in requirement. Therefore, in the above situation exemption from capital gains tax on transfer of investment assets between holding and wholly-owned subsidiary companies will continue as long as the holding company continues to hold the entire share capital of subsidiary company and if investment assets are converted into trading asset, till they are not sold by the transferee company.

(The authors are Executive Director and Associate Director, respectively, KPMG India Private Ltd.)