Taxation of Capital Gains under Direct Taxes Code

1.2 Prior to introduction of the DTC Bill, 2010, the Government had issued the DTC Bill, 2009 with a Discussion Paper for public debate on 12-8-2009. The DTC Bill, 2009, proposed to introduce several changes in the provisions relating to capital gains. There was a proposal to do away the present distinction between short-term and long-term capital gains. It was also proposed to abolish the present exemption/concession available to capital gains on sale of listed securities on which STT is paid. The concessional rate for long-term/short-term capital gains was also proposed to be abolished and there was a proposal to levy tax on capital gains at the normal rate applicable to other income.

1.3 Several representations were made to the Government objecting to these proposals. Based on the above representations, a Revised Discussion Paper was issued by the Government on 15-6-2010 and the revised DTC Bill, 2010, was introduced in the Parliament in August, 2010.

1.4 In the revised Discussion Paper of June, 2010, it was clarified that the original proposals of DTC – 2009 for taxation of capital gains have been modified as under:

(a) Income from capital gains will not be considered as income from ordinary sources.

2. Concept of capital gains

3. Computation of capital gains

3.2 It may be noted that the word ‘Transfer’ is defined in section 314(267). This definition is very elaborate as compared to section 2(47) of the Income-tax Act (ITA). The above definition provides that ‘Transfer’ in relation to a ‘Capital Asset’ includes the following:

(i) Sale, exchange or extinguishment of any asset or any rights in it;

3.3 The capital gains arising from the transfer of personal effects and agricultural land is exempt from income tax. The term ‘personal effects’ is defined in section 314(190) and the term ‘agricultural land’ is defined in section 314(12). This definition states that the land, wherever situated, if used for agricultural purposes will be treated as agricultural land.

3.4 In general, the capital gains will be equal to the full consideration from the transfer of the investment asset minus the cost of acquisition, cost of improvement thereof and transfer-related incidental expenses. However, in the case of an investment asset which is transferred anytime after one year from the end of the financial year in which it is acquired, the cost of acquisition and cost of improvement will be adjusted on the basis of cost inflation index.

3.5 Capital gains from all investment assets will be aggregated to arrive at the total amount of current income from capital gains. This will, then, be aggregated with unabsorbed capital loss at the end of the preceding financial year to arrive at the total amount of income under the head ‘Capital gains’. If the result of the aggregation is a loss, the total amount of capital gains will be treated as ‘nil’ and the loss will be treated as unabsorbed current capital loss at the end of the financial year. This unabsorbed loss will be carried forward for adjustment against capital gains in subsequent years. There is no time limit for such carry forward and set-off of losses.

4.2 Section 46 of the Code provides that the exemption granted u/s.47 of the Code in respect of certain transfers of investment assets and u/s.55 of the Code in respect of certain rollover of investment assets will become taxable in the F.Y. in which the conditions specified in section 47 or 55 are violated. This provision is on the same lines as in the existing sections 47A, 54, 54B, 54F, 54EC, etc. of ITA.

4.3 Section 48 of the Code explains about the F.Y. in which the income arising on non-compliance with the conditions laid down in section 47 will become taxable. This section also explains about the F.Y. in which enhanced additional compensation received on compulsory acquisition of property will be taxable. Further, the section also explains as to when an immovable property will be considered to have been transferred. These provisions are similar to sections 45(1), 45(4), 45(5) and 46 of ITA with some modifications.

4.4 It is significant to note that the existing sec-tion 45(4) of ITA provides that if any capital asset is transferred by way of distribution of capital as-sets to any partner or partners on dissolution of a firm or AoP or otherwise, the difference between the market value of the asset and its cost will be taxable as capital gains in the hands of the Firm or AoP. This position will continue under the Code in view of item 6(ii) of the table below section 48(1) r.w.s 50(2)(d) of the Code. However, in the case of retirement of a partner, the Courts have held that the word ‘otherwise’ in the existing section 45(4) applies when a partner retires from the Firm or AoP and takes away any asset of the Firm or AoP as part of the amount due on retirement. Now, section 48(2)(b) of the Code, read with item 7 of the table below section 48(1) and section 50(2) (f), provides that “Any money or asset received by a participant (Partner/Member) on account of his retirement from an unincorporated body (Firm, LLP, AoP, BoI) shall be deemed to be the income of the recipient of the F.Y. in which the money or asset is received”. This will mean that if the amount due to the retiring partner as per the books of the Firm, AoP or BoI is Rs.1.5 crore but the amount received and market value of the asset received on his retirement is Rs.2.5 crore, the retiring partner will have to pay tax on capital gains under the Code.

4.5 Under section 51(2) of the Code, in the case of equity shares of a company and units of equity-oriented fund of a M.F., held for more than one year, the capital gain will be exempt from tax if STT is paid. It may be noted that there is difference in the wording of section 51(2) and 51(3). U/s.51(2) the requirement is holding of shares, etc. for more than one year, whereas u/s.51(3) the period for holding other assets is at least one year after the end of the F.Y. in which the asset is acquired.

4.6 In the above case if the STT is paid and the shares/units are held for less than one year, 50% of the capital gain will be exempt and tax at normal rate will be payable on the balance of 50%.

4.7 It may be noted that under item No. 32 of Schedule 6 it is provided that the capital gain arising from transfer of the following assets will not be liable to tax under DTC:

(i)    Agricultural land in a rural area as defined in section 314(221)r.w.s 314 (284). This definition is similar to the definition in section 2(14)(iii) of ITA.

(ii)    Personal effects as defined in section 314 (190) which is similar to section 2(14)(ii) of ITA.

(iii)    Gold Deposit Bonds.

5.    Full value of consideration
5.1 The provisions relating to computation of capital gains on transfer of an investment asset and determination of the full value of the consideration are contained in sections 49 and 50 of the Code. These provisions are similar to the provisions of sections 45(2), 45(3), 45(5), 48 and 50C of ITA with certain modifications. In the case of sale of land or building, section 50(2)(h) of the Code provides that stamp duty value of the asset will be considered as full value of the consideration. The term ‘Stamp duty value’ is defined in section 314(246) on the same lines as in section 50C of ITA with the exception that there is no provision for refer-ence to valuation officer in the event such value is disputed by the assessee. Further, section 50(2) r.w.s 314(267) and 314(93) of the Code provides that in respect of conversion of investment asset into stock-in-trade, distribution of assets to partici-pants on dissolution of the unincorporated body or retirement of a participant, etc. the fair market value of the asset on the date of transfer will be determined according to the method prescribed by the CBDT.

5.2 It may be noted that u/s.45(3) of the ITA it is provided that when the partner/member of a firm, LLP, AoP or BoI in which he becomes a partner/ member and contributes a capital asset as his capital contribution in the entity, the amount credited to this account in the entity will be considered as full value of the consideration and capital gain tax will be payable by him on this basis. This benefit is not available at present when a person becomes a shareholder in a company and he is allotted shares in the company against any transfer of any asset to the company. Now, section 50(2)(c) of the Code provides that the amount recorded in the books of the company or an unincorporated body as value of the investment asset contributed by the shareholder or participant will be the full value of the consideration and the capital gain will be computed in the hands of the transferor on that basis.

6.    Cost of acquisition and indexation
6.1 As stated earlier, section 49 of the Code provides that capital gain on transfer of an investment asset is to be computed by deducting from the full value of the consideration, the cost of acquisition and the cost of improvement. The term ‘Cost of acquisition’ is defined in section 53 read with the 17th Schedule. The term ‘Cost of improvement’ is defined in section 54. These provisions are more or less on the same lines as sections 48, 49 and 55 of ITA. It may, however, be noted that when the investment asset is received by way of gift, will, inheritance, etc., it is provided that the cost will be the cost of acquisition in the hands of previous owner. However, the period during which the previous owner held the asset cannot be added in computing the total period for which the assessee has held the asset, as there is no provision for this purpose corresponding to the provision in section 2(42A) of ITA. Existing section 55(3) of ITA provides that if the cost of the asset in the hands of the previous owner cannot be ascertained, the market value on the date on which the previous owner acquired the asset will be considered as his cost. Now, section 53(7)(c) of the Code provides that if the cost of investment asset in the hands of the previous owner cannot be determined or ascer-tained, the said cost will be taken as ‘nil’. Similarly, in the case of the assessee if a self-generated asset or any other investment asset is acquired and the cost of such asset cannot be determined or ascertained for any reason, it shall be considered as ‘nil’.

6.2 Section 52 of the Code gives mode of computation of indexation of certain investment assets in specified cases. The method prescribed in this section is similar to the provision in the existing section 48 of ITA. However, some modification in the scheme under the Code is made as under:

(i)    Under section 2(29A)r.w.s 2(42 A) of ITA, a capital asset which is held for more than three years is considered as a ‘long-term asset’. U/s.51(3) of the Code, it is provided that if the investment asset is held for more than one year from the end of the financial year in which the asset is acquired, the benefit of indexation of cost will be available.

In other words, if the investment asset is acquired on 1-5-2010, it will be considered as long-term capital asset if it is sold on or after 1-4-2012 under the Code. In the following discussions such investment asset is referred to as a ‘long-term asset’.

(ii)    In the case of any investment asset, if it is a long-term asset as explained in (i) above, the assessee will be entitled to deduct indexed cost of the asset as provided in section 52 of the Code from the full value of the consideration for computation of capital gain. The method for working out indexed cost is the same as in section 48 of ITA. However, the base date for determining the indexed cost will be 1-4-2000 under DTC instead of 1-4-1981 provided in ITA.

(iii)    At present, section 55(2)(b) of ITA provides that if a capital asset is acquired before 1-4-1981, the assessee has an option to substitute the fair market value of the asset as on 1-4-1981 for its cost.

Now, section 53(1)(b) of the Code provides that if the investment asset is acquired before 1-4-2000, the assessee will have the option to substitute fair market value on 1-4-2000 for its cost.

7.    Relief on reinvestment of consideration
Section 55 of the Code provides for relief for roll-over of long-term investment asset in the case of an Individual or HUF. This provision is similar to the existing provisions for relief on reinvestment of capital gains in sections 54, 54B and 54F of ITA with the following modifications:

(i)    At present, the exemption is available if ‘capital gain’ on sale of a capital asset is reinvested in the specified assets u/s.54, 54B or 54EC of ITA. In case of section 54F of ITA, the ‘Net consideration’ on sale is required to be reinvested. Now, u/s.55 of the Code, the benefit of exemption is available on reinvestment of ‘Net consideration’ in all the cases.

(ii)    The rollover relief is available for only two categories of long-term assets viz. (a) agricultural land, and (b) any other investment asset.

(iii)    In the case of agricultural land there is no distinction between rural and urban land. The only condition is that it is assessed to land revenue or local cess and used for agricultural purposes. Further, this land should be an agricultural land during two years prior to the F.Y. in which it is transferred and was acquired by the assessee at least one year before the beginning of the F.Y. in which it is transferred. If these conditions are satisfied and the assessee invests the net consideration on sale of such agricultural land for the purchase of one or more pieces of agricultural land within a period of three years from the end of the F.Y. in which the original agricultural land was sold, he will get exemption in proportion to the amount so invested.

(iv)    In the case of any other long-term investment asset, the above rollover benefit will be available, if the net consideration is invested in the purchase or construction of a residential house within a period of three years from the end of the F.Y. in which the original asset was sold. For getting this benefit there are two conditions as under:

(a)    The assessee should not be the owner of more than one residential house (other than the residential house in which such investment is made) on the date of sale of original asset.

(b)    The residential house in which the above investment is made to get rollover benefit should not be transferred within one year from the end of the F.Y. in which such investment is made.

It is also provided in section 55 of the Code, that the above rollover benefit will be available if the investment in the new asset is made within a period of one year before the sale of the original asset.

(vi)    It is also provided in the above section that the net consideration on sale of the original asset should be reinvested for acquiring the new asset, as stated above, before the end of the F.Y. in which the original asset is sold or within six months from the date of such sale, whichever is later. If this is not done, the net consideration or balance thereof should be deposited with Capital Gains Deposit Scheme to be framed by the Government. The amount so deposited should be used within three years from the end of the F.Y. in which the original asset is sold. If it is not so used, the same will be taxable in F.Y. in which the period of three years expires.

(vii)    From the above, it will be evident that the present concession of investing the capital gain on sale of residential house for purchase of another residential house even if the assessee is owner of more than one residential house u/s.54 of the ITA will not be available. Further, the benefit of investment in approved bonds up to Rs.50 lakh u/s.54EC of ITA will also not be available.

8.    Income of FII
As stated earlier, definition of investment asset u/s.314(141) of the Code includes any shares or securities held by a Foreign Institutional Investor (FII). In view of this, FII engaged in trading of shares or securities in India will not be entitled to claim exemption under the applicable DTAA on the ground that it is carrying on business in India and has no permanent establishment in India. Under the Code, the surplus from these transactions will be considered as income from capital gains.

9.    Slump sale
The definition of investment asset also includes any undertaking or division of a business. Section 53(5) provides that if there is any slump sale of any undertaking or division of a business, the cost of acquisition of such asset will be the ‘net worth’ of such undertaking or division. If such undertaking or division is sold after the end of one year from the end of the financial year in which it was acquired or established, the benefit of indexation u/s.51 and 52 of the Code will be available. Net worth of such undertaking or division will be worked out as may be prescribed by the CBDT u/s.314(166). The term ‘Slump sale’ is defined in section 314(234) on the same lines as section 2(42C) of ITA.

10.    Aggregation of capital gains and losses
10.1 Income from capital gains (short-term or long-term) from various investment assets, whether positive or negative, shall be first aggregated and any carried forward loss under this head from earlier years shall be deducted therefrom. If the net result is loss, it shall be carried forward to next year. There is no time limit for such carry forward of losses. If the net result is positive, it shall be aggregated with income under other heads. It may be noted that there is a departure from the provisions of ITA where income from long-term capital gains is taxed at a separate lower specified rate. Under DTC long- term or short-term capital gains is taxable at the normal rate applicable to other income.

10.2 It may be noted that there is no provision for adjustment of short-term or long-term capital losses carried forward from F.Y. 2011-12 (A.Y. 2012-13)    and earlier years against capital gains for F.Y. 2012-13 and subsequent years under DTC.

11.    Treatment of losses in certain specified cases

11.1    Section 64 and 65 of DTC provide for treatment of losses in specified cases as under:

(i)    On conversion of unlisted company into LLP — It may be noted that as stated earlier, u/s.47(1) (J) exemption from capital gain is given in the case of conversion of an unlisted company into a LLP. There are certain conditions for this purpose which are similar to section 47(xiii b) of ITA. Section 64(1) provides that unabsorbed current loss from ordinary sources in the case of an unlisted company shall be available for set-off in the case of LLP against its current aggregate income from ordinary sources of subsequent years. Similarly, unabsorbed current capital loss of the company shall be set off against current capital gains in the case of LLP in the subsequent years. This section is similar to section 72A(6A) of ITA. If the conditions laid down in section in section 47(1)(J) of DTC are not complied with, the set-0ff of loss so allowed in any F.Y. can be withdrawn by rectification of the assessment order.

(ii)    On Business Reorganisation — It may be noted that as stated earlier, u/s.47(1)(n) exemption from capital gain is given in the case of conversion of sole proprietary concern into a limited company. There are certain conditions for this purpose which are similar to section 47(xiv) of ITA. U/s.64(2) it is provided that unabsorbed current loss from ordinary sources in the case of sole proprietor shall be set off against current income from ordinary sources of the company. Similarly, unabsorbed current capital loss in the case of sole proprietor will be set off against current capital gain in the subsequent year in the case of the company. If the conditions laid down in section 47 (1)(n) of DTC are not complied with, the set-off of loss so allowed in any F.Y. can be withdrawn by rectification of assessment order.

11.2    Treatment of unabsorbed losses on change in Constitution

(i)    Changes in constitution of unincorporated body — Section 65 provides that in the case of change in the constitution of an unincorporated body (i.e., Firm, LLP, AoP or BoI) on account of death/retirement of a participant, the unabsorbed loss of that entity (including capital loss) shall be reduced in proportion of the loss attributable to the deceased/retiring participant and allowed to be carried forward and set off in the subsequent years as under:

(a)    Proportionate unabsorbed loss from ordinary sources shall be carried forward and set off against current income from ordinary sources in the subsequent years.

(b)    Proportionate unabsorbed capital loss shall be carried forward and set off against current capital gain in the subsequent year.

This section is similar to section 78 of ITA with the difference that section 78 of ITA applies to a Firm or LLP, whereas section 65 of DTC applies to a Firm, LLP, AoP or BoI.

(ii)    Changes in shareholding of closely-held companies — Section 66 of DTC is similar to section 79 of ITA. It provides that in the case of a closely-held company, if the persons holding not less than 51% of voting power on the last day of the F.Y. when the loss under the ordinary sources or capital gains was incurred, are not holding this voting power on the last day of the F.Y. when the income from such sources is earned, such unabsorbed loss cannot be the set-off against the income from such sources in that F.Y. The only difference between section 79 of ITA and section 66 of DTC is that section 79 does not apply to set off of unabsorbed depreciation, whereas u/s.66 of DTC loss includes depreciation.

12.    Filing return of loss
Section 67 provides that if the return of tax bases showing loss is not filed before the due date for filing the return, the loss under the head ordinary sources, special sources, capital gains, speculation, horse races activities, etc. shall not be allowed to be carried forward or set off in the subsequent years. This section is similar to section 80 of ITA. Here also it may be noted that section 80 does not refer to unabsorbed depreciation, but u/s.67 loss will include depreciation also.

13.    Some issues
From the above discussion about provisions relating to taxation of capital gains proposed to be introduced in DTC w.e.f. 1-4-2012, it is evident that the existing provisions will stand substantially modified. Some of the following issues require consideration.

(i)    The word ‘Asset’ is defined to mean (a) a business asset or (b) an investment asset. Again, a business asset is further classified as business trading asset and business capital asset. So far as business trading asset is concerned, it will be allowed as revenue expenditure in computing business income. As regards business capital asset, only depreciation will be allowed. Thus, only investment asset will form part of the computation of capital gains.

(ii)    The existing distinction between long-term and short-term capital asset is now proposed to be modified. It an investment asset is held for more than one year after the end of the F.Y. in which it is acquired, it will be considered as a long-term capital asset.

(iii)    The existing concept of determination of indexed cost for computing long-term capital gain has been retained. The base date for this purpose will be 1-4-2000, instead of 1-4-1981.

(iv)    The existing provision for granting exemption in respect of long-term capital gain on sale of securities, where STT is paid, will continue. As regards short-term capital gain in such transactions, only 50% of such capital gain will be taxable at normal rate. Therefore, the effective tax rate shall not exceed 15%.

(v)    If net result under the head capital gain (long-term or short-term) is positive, it will be added to income under other heads and tax will be payable at normal rate of tax applicable to the total income. If the net result is capital loss, the same will be carried forward without any time limit. There is no concessional rate for taxation of long-term capital gain as provided in section 112 of ITA.

(vi)    There is, however, no provision in DTC for adjustment of short-term or long-term capital losses carried forward under ITA from F.Y. 2011-12 (A.Y. 2012-13) and earlier years against capital gains for F.Y. 2012-13 and subsequent years.

(vii)    Existing section 47(xiii) of ITA provides that conversion of a partnership firm into limited company does not attract any capital gains tax if certain conditions are complied with. There is no corresponding provision in DTC. Similarly, there is no provision in DTC for such exemption when a partnership firm is converted into an LLP.

(viii)    As discussed in para 5.1 above, there is no provision in DTC for reference to valuation officer if the assessee objects to the stamp duty valuation in respect of sale of immovable property. Therefore, stamp duty valuation will now become mandatory.

(ix)    As discussed in para 7(vii) above, there is no provision in DTC similar to section 54EC of ITA to enable an assessee to deposit up to Rs.50 lakh, out of long-term capital gains in notified Bonds. Thus, assessees selling small value investment assets will not be able to claim exemption from long-term capital gains tax to this extent.

Let us hope that some of the above anoma-lies are removed before DTC is enacted by the Parliament.