Capital gains arise when an individual or entity sells or transfers a capital asset for an amount higher than its original purchase cost. These gains are categorized as taxable income under the heading “Capital Gains.” The difference between the sale consideration and the acquisition cost, after adjusting for allowable deductions, constitutes the capital gain. Capital assets typically include immovable properties, shares, mutual fund units, gold, and other valuable possessions.
Basis of Charge for Capital Gains
Income is taxed under the head “Capital Gains” when the following essential conditions are fulfilled:
- There is an existing capital asset.
- The asset is transferred within the relevant financial year.
- The transfer results in a capital gain.
- The capital gain is not specifically exempt from taxation.
When these conditions are satisfied, the gains derived from the transfer of the capital asset are subjected to tax based on the relevant tax rates and provisions.
Meaning of Capital Asset
The term “capital asset” is defined under Section 2(14) of the Income Tax Act. This definition is broad and inclusive, covering not only the items explicitly mentioned but also any other property fitting the general and natural meaning of the term.
Positive List of Capital Assets
Capital assets encompass:
- Rights associated with an Indian company, including management rights, control rights, or any other related rights.
- Any property, whether or not connected with the assessee’s business or professional activities.
- Securities owned by Foreign Institutional Investors (FIIs), provided they are invested in compliance with SEBI regulations.
- Securities held by investment funds operating under SEBI guidelines or as per the International Financial Services Centres Authority Act.
- Specific Unit Linked Insurance Policies (ULIPs) where exemption under Section 10(10D) does not apply.
Negative List of Capital Assets
Certain assets are specifically excluded from being classified as capital assets:
- Stock-in-trade, except for securities.
- Personal effects used by the assessee or their dependent family members.
- Agricultural land situated in rural areas that meet prescribed population thresholds.
- Particular types of bonds such as Gold Bonds and Bearer Bonds.
- Deposits under the Gold Deposit Scheme, 1999, or under the Gold Monetisation Scheme, 2015.
Personal Effects and Their Treatment
Movable assets such as clothing, furniture, and other items for personal use by the owner or dependent family members are not considered capital assets. However, specific categories of items are excluded from this exemption and are treated as capital assets, even if held for personal use. These items include:
- Jewellery
- Archaeological collections
- Drawings and paintings
- Sculptures
- Any other forms of artwork
Rural Agricultural Land – Not a Capital Asset
Agricultural land located in specified rural areas is not treated as a capital asset. Determination depends on its geographical location and proximity to urban centers. Agricultural land will not be considered a capital asset if it meets the following conditions:
- It is situated outside the jurisdiction of a municipality or cantonment board with a population of 10,000 or more.
- It lies beyond a specific aerial distance from the local limits of such municipality or cantonment area, which varies as follows:
- 2 kilometers if the population is between 10,000 and 1,00,000
- 6 kilometers if the population is between 1,00,000 and 10,00,000
- 8 kilometers if the population exceeds 10,00,000
Classification of Capital Assets
Capital assets are classified into two categories based on their period of holding. This classification is crucial as it determines the method of computation and the applicable tax rates on capital gains.
Short-term Capital Assets
Assets held for a period of 24 months or less are considered short-term capital assets. However, there are specific exceptions where the holding period for classification as a short-term asset is restricted to 12 months. These exceptions include:
- Listed shares on a recognized stock exchange in India
- Listed debentures and bonds
- Units of equity-oriented mutual funds
- Listed units of debt-oriented mutual funds
- Zero-coupon bonds
Long-term Capital Assets
Assets held for a period exceeding 24 months are classified as long-term capital assets. The reduced 12-month holding period applies exclusively to the financial assets listed above.
Understanding whether an asset is categorized as short-term or long-term is pivotal in determining how the capital gains arising from its transfer will be taxed.
Transfer of Capital Assets
Capital gains are triggered by the transfer of a capital asset. The term “transfer” is interpreted broadly and includes various modes of transaction, such as:
- Sale of a capital asset
- Exchange or relinquishment of ownership
- Extinguishment of rights associated with the asset
- Compulsory acquisition of the asset by a statutory authority
Certain transactions are excluded from the ambit of “transfer.” These include:
- Distribution of assets upon the liquidation of a company
- Distribution of assets during the total or partial partition of a Hindu Undivided Family
- Transfers through gifts, wills, or trusts, except where ESOPs are concerned
- Transfers between an Indian holding company and its wholly-owned Indian subsidiary
- Transfers arising out of amalgamations or demergers, subject to specified conditions
- Redemption of Sovereign Gold Bonds issued by the Reserve Bank of India
- Donations or transfers of artworks, archaeological collections, or manuscripts to recognized institutions like national museums or public archives
- Conversion of bonds or debentures into equity shares
- Transfers under reverse mortgage arrangements
These exclusions ensure that certain transactions, which do not result in actual economic gains or shifts in ownership for consideration, are not subjected to capital gains tax.
Computation of Capital Gains
The method of computing capital gains varies depending on whether the asset in question is classified as a short-term or long-term capital asset.
Computation of Short-term Capital Gains (STCG)
Short-term capital gains are computed by deducting the following from the full value of consideration received upon the transfer of the asset:
- Cost of Acquisition
- Cost of Improvement
- Expenses incurred wholly and exclusively in connection with the transfer
The resulting figure represents the short-term capital gains taxable under the Income Tax Act.
Computation of Long-term Capital Gains (LTCG)
For long-term assets, the computation involves indexing the cost of acquisition and improvement to neutralize the impact of inflation. The indexed cost is determined using the Cost Inflation Index (CII) notified annually by the Central Board of Direct Taxes (CBDT). The formula for computing long-term capital gains is as follows:
- Sale Consideration
- Less: Indexed Cost of Acquisition
- Less: Indexed Cost of Improvement
- Less: Transfer-related Expenses
The resulting amount constitutes the taxable long-term capital gains.
Cost of Improvement Considerations
Expenditures incurred for the improvement of a capital asset are deductible from the sale consideration. However, any expenditure on improvement carried out prior to April 1, 2001, is disregarded for the purpose of capital gains computation.
Capital Gains Exempt Under Section 10
The Income Tax Act provides exemptions for capital gains arising from specific transactions. These exemptions, covered under Section 10, include:
- Gains from the transfer of units under the US64 Scheme
- Gains arising from the compulsory acquisition of urban agricultural land used for agricultural purposes by the owner or their family
- Gains from the conversion of foreign bank branches into Indian subsidiaries
- Gains arising from acquisitions under the Right to Fair Compensation and Transparency in Land Acquisition, Rehabilitation and Resettlement Act, 2013
- Gains related to transactions under the Andhra Pradesh Land Pooling Scheme
- Amounts received under life insurance policies (including bonuses) that qualify for exemption under Section 10(10D)
These exemptions help mitigate the tax liability in specific scenarios and promote reinvestment or compliance with government policies.
Special Scenarios in Capital Gains Computation
Capital gains computation is straightforward in general circumstances, but there are specific scenarios where unique methods of calculation apply. These cases require careful understanding of provisions to ensure accurate computation.
Inherited Property – Cost of Acquisition Based on Previous Owner
When a person inherits property through gift, will, succession, or any mode of inheritance, the cost of acquisition of the asset is deemed to be the cost at which the previous owner acquired it. This ensures that inherited property does not escape the tax net while also avoiding double taxation.
Fair Market Value as on April 1, 2001
For capital assets acquired before April 1, 2001, the assessee has the option to consider the Fair Market Value (FMV) of the asset as on that date as the deemed cost of acquisition. This provision helps in eliminating undue hardship due to historical costs which would otherwise inflate capital gains due to inflation.
Depreciable Assets – Section 50 Provisions
For assets on which depreciation has been claimed, the gains arising from the sale are considered as short-term capital gains, even if the asset is held for more than 24 months. The computation is done by reducing the written down value (WDV) of the block of assets from the full value of consideration.
Forfeiture of Advance Money
Advance money received and forfeited by the seller due to failure of negotiation or breach of contract by the buyer is taxed under Section 56(2)(ix) under the head “Income from Other Sources.” It does not reduce the cost of acquisition for capital gains purposes.
Conversion of Capital Asset into Stock-in-Trade
When a capital asset is converted into stock-in-trade, the notional capital gain is computed based on the Fair Market Value on the date of conversion. The actual capital gain is taxed in the year when the stock-in-trade is sold.
Partner’s Capital Contribution in Kind
When a partner contributes a capital asset to a firm as capital contribution, it is treated as a transfer, and the fair market value of the asset on the date of contribution is deemed to be the full value of consideration for computing capital gains.
Distribution of Assets by Firm/AOP/BOI
When a firm, Association of Persons (AOP), or Body of Individuals (BOI) distributes assets upon dissolution or reconstitution, the difference between the market value of the asset and its recorded value is treated as capital gains in the hands of the entity.
Compulsory Acquisition of Capital Assets
If a capital asset is compulsorily acquired under law, the capital gain is chargeable to tax in the year in which the compensation is received. Any enhanced compensation received in subsequent years is also chargeable to tax as capital gains.
Capital Gains for Non-Residents on Shares and Debentures
Non-resident individuals are taxed on capital gains arising from the transfer of shares or debentures of Indian companies. The first-in-first-out (FIFO) method applies for determining the holding period in the case of dematerialized securities.
Self-Generated Assets
For self-generated assets like goodwill, trademarks, brand names, tenancy rights, or route permits, the cost of acquisition is generally taken as nil, except where specific rules provide otherwise.
Bonus Shares
For bonus shares, the period of holding is counted from the date of allotment of such shares. In most cases, the cost of acquisition is taken as nil, though specific exceptions may apply in cases governed by the SEBI regulations.
Transfer of Rights Entitlement
When an assessee transfers rights entitlement (e.g., rights to subscribe to additional shares), the cost of acquisition is considered as nil, and the entire sale proceeds are treated as capital gains.
Conversion of Debentures/Bonds into Shares
On conversion of debentures or bonds into shares, the cost of acquisition of the resultant shares is determined based on the proportionate cost of the original debentures or bonds.
Dematerialized Securities and FIFO Method
For securities held in dematerialized form, the cost of acquisition and the period of holding are determined on a First-In-First-Out (FIFO) basis, ensuring a uniform method of calculation for all demat account holders.
Insurance Compensation
When a capital asset is destroyed, any insurance compensation received is treated as consideration for computing capital gains. The resultant gains are taxable in the year of receipt of such compensation.
Sweat Equity Shares
Sweat equity shares allotted to employees are taxed based on the fair market value (FMV) on the date of exercise of the option or vesting, depending on the allotment period. The FMV is considered as the cost of acquisition for computing capital gains upon subsequent sale.
Buy-back of Shares
In cases of buy-back of shares by a company, the difference between the consideration received and the cost of acquisition is treated as capital gains and is taxed in the hands of the shareholder.
Conversion of Stock-in-Trade into Capital Asset
When stock-in-trade is converted into a capital asset, the fair market value on the date of conversion is considered as the deemed cost of acquisition for future capital gains computation.
Section 112A – Special LTCG Computation for Equity Assets
For long-term capital gains arising from the transfer of listed equity shares or units of equity-oriented mutual funds, Section 112A provides for a concessional tax rate. Gains exceeding a threshold limit are taxed after considering the fair market value as on January 31, 2018, or the actual sale price, whichever is lower.
Deemed Transfers and Special Cases
Certain transactions, although not involving a conventional sale, are treated as transfers for capital gains purposes due to deemed consideration rules or anti-avoidance measures.
Section 50C – Sale of Land or Building
Under Section 50C, if the sale consideration declared by the seller is lower than the stamp duty value adopted by the authorities, the stamp duty value is deemed to be the full value of consideration for capital gains computation. A 10% tolerance margin is allowed.
Transfer Without Ascertainable Consideration
In cases where the consideration for a transfer of a capital asset is not ascertainable or cannot be determined, the Fair Market Value of the asset on the date of transfer is deemed to be the consideration received.
Joint Development Agreements (JDAs)
When an individual or Hindu Undivided Family (HUF) transfers land or building under a Joint Development Agreement, capital gains tax liability arises in the year when the competent authority issues a completion certificate. The stamp duty value of the share in the developed property, along with any monetary consideration received, is treated as the full value of consideration.
Section 50CA – Transfer of Unlisted Shares
If unlisted shares are transferred at a price lower than their Fair Market Value, Section 50CA mandates that the Fair Market Value shall be considered as the deemed full value of consideration for capital gains computation.
Section 50AA – Units of Specified Funds and Market-Linked Debentures
For units of specified mutual funds, unlisted debentures, or market-linked debentures transferred below their Fair Market Value, Section 50AA prescribes that such Fair Market Value be deemed as the full value of consideration.
Reconstitution of Firm/AOP/BOI
When there is a reconstitution of a firm, AOP, or BOI, and a partner/member receives any money or capital asset in excess of their capital account balance, the difference is treated as capital gains in the hands of the firm/AOP/BOI.
Reverse Mortgage Transactions
Transfers involved in reverse mortgage schemes are not treated as transfers for capital gains purposes, thus avoiding immediate tax implications.
Conversion of Bonds/Debentures into Equity Shares
When bonds, debentures, or debenture-stock are converted into equity shares, such conversion is not treated as a transfer. However, the resultant shares will be subject to capital gains tax upon their subsequent sale.
Rupee-Denominated Bonds and Specified Securities
Transfers of rupee-denominated bonds of Indian companies, or specific notified securities made by non-residents on recognized stock exchanges in International Financial Services Centres (IFSCs), are excluded from the ambit of capital gains tax if the consideration is received in foreign currency.
Business Reorganization
In cases of business reorganization involving transfer of assets from a predecessor co-operative bank to a successor entity, the transaction is not regarded as a transfer, provided the prescribed conditions are satisfied.
Lending of Securities
Transfers involved in schemes for the lending of securities are not treated as transfers for capital gains computation, subject to compliance with stipulated guidelines and conditions.
Conversion of Firm or Sole Proprietorship into Company
The transfer of assets during the conversion of a firm or sole proprietorship into a company is not treated as a transfer under capital gains, provided conditions laid down in the Act are fulfilled.
Transfer of Work of Art to Public Institutions
Any transfer of artworks, archaeological collections, or manuscripts to the Government, public museums, or notified institutions is not treated as a transfer for the purpose of capital gains taxation.
Exemptions under Sections 54 to 54GB
Capital gains exemptions under the Income Tax Act provide significant relief to taxpayers who reinvest their capital gains in specified assets or meet certain conditions. These exemptions encourage investments in residential properties, bonds, business undertakings, and infrastructural development. We focus on the various exemptions available from Section 54 to Section 54GB.
Section 54 – Exemption on Sale of Residential Property
Section 54 provides an exemption to individuals and Hindu Undivided Families (HUFs) on long-term capital gains arising from the sale of a residential house, provided the gains are reinvested in another residential property.
Conditions for Exemption
- The capital asset transferred must be a long-term residential house property.
- The assessee should purchase another residential house within one year before or two years after the date of transfer.
- Alternatively, the assessee can construct a residential house within three years from the date of transfer.
Amount of Exemption
The exemption is the lower of the amount of capital gain or the cost of the new residential house. If the new property is sold within three years of purchase or construction, the exemption claimed earlier is reversed and added to the income in the year of sale.
Section 54B – Exemption on Sale of Agricultural Land
Section 54B provides relief on capital gains arising from the transfer of agricultural land, provided the proceeds are reinvested in purchasing new agricultural land.
Conditions for Exemption
- The assessee (individual or HUF) should have used the land for agricultural purposes in the two years immediately preceding the date of transfer.
- The new agricultural land must be purchased within two years of the sale.
Amount of Exemption
The exemption is restricted to the amount of capital gain or the cost of the new agricultural land, whichever is lower.
Section 54D – Exemption on Compulsory Acquisition of Industrial Land or Building
Section 54D offers an exemption for capital gains arising from the compulsory acquisition of land or buildings used for industrial purposes.
Conditions for Exemption
- The land or building should have been used by the assessee for industrial purposes for at least two years before acquisition.
- The assessee must acquire new land or building for industrial use within three years from the date of receipt of compensation.
Amount of Exemption
The exemption is equal to the capital gain invested in acquiring or constructing new industrial land or building.
Section 54EC – Exemption on Investment in Specified Bonds
Section 54EC allows exemption on long-term capital gains if the gains are invested in specified bonds issued by:
- National Highways Authority of India (NHAI)
- Rural Electrification Corporation (REC)
- Power Finance Corporation (PFC)
- Indian Railway Finance Corporation (IRFC)
Conditions for Exemption
- Investment in specified bonds must be made within six months from the date of transfer.
- The maximum investment limit is Rs. 50 lakh per financial year.
Lock-in Period
The bonds must be held for a minimum of five years. Premature transfer or conversion leads to withdrawal of the exemption.
Section 54EE – Exemption on Investment in Specified Funds
Section 54EE provides an exemption on long-term capital gains if invested in units of a notified fund.
Conditions for Exemption
- The investment should be made within six months from the date of transfer.
- The maximum amount eligible for exemption is Rs. 50 lakh.
Lock-in Period
The units of the specified fund must be held for at least three years.
Section 54F – Exemption on Sale of Any Long-term Capital Asset Other Than Residential House
Section 54F provides an exemption to individuals and HUFs on the sale of long-term capital assets other than a residential house, if the net sale consideration is invested in purchasing or constructing a residential house.
Conditions for Exemption
- The assessee should not own more than one residential house on the date of transfer (excluding the new house purchased).
- The entire net sale consideration must be invested in purchasing a residential house within one year before or two years after the transfer or constructing it within three years.
Amount of Exemption
The exemption is proportionate if the entire sale proceeds are not invested. The formula is:
Exemption = Capital Gain × (Amount Invested ÷ Net Sale Consideration)
If the new residential property is sold within three years, the exemption is withdrawn.
Section 54G – Exemption on Shifting Industrial Undertaking to Rural Area
Section 54G provides an exemption for capital gains arising from the transfer of assets in urban areas used for industrial purposes when the business is shifted to a rural area.
Conditions for Exemption
- The transferred assets should be land, building, plant, or machinery used for business or industrial purposes.
- The assessee must acquire new assets (land, building, plant, or machinery) in a rural area.
- The shifting should be completed within three years from the date of transfer.
Amount of Exemption
The exemption is the amount of capital gain invested in acquiring new assets for shifting the undertaking.
Section 54GA – Exemption on Shifting Industrial Undertaking to SEZ
Section 54GA is similar to Section 54G but applies when the industrial undertaking is shifted from an urban area to a Special Economic Zone (SEZ).
Conditions for Exemption
- The transferred assets must be used for business or industrial purposes.
- The new assets should be acquired and installed in the SEZ.
- The shifting should be completed within three years of the transfer.
Amount of Exemption
The exemption is equivalent to the amount of capital gain reinvested in acquiring new assets in the SEZ.
Section 54GB – Exemption on Transfer of Residential Property for Investment in Eligible Startups
Section 54GB provides an exemption on long-term capital gains arising from the sale of a residential property if the net consideration is invested in the equity shares of an eligible startup.
Conditions for Exemption
- The assessee should be an individual or HUF.
- The net consideration must be invested in the equity shares of an eligible company before the due date of filing the return.
- The company must utilize the amount for purchasing new assets within one year from the date of subscription.
Lock-in Period
Both the assessee and the company are required to hold the equity shares and new assets for a minimum of five years.
Amount of Exemption
The exemption is equal to the amount invested in the equity shares of the eligible company.
Capital Gains Account Scheme (CGAS)
When taxpayers are unable to utilize the entire capital gains for investment before the due date of filing the return, they can deposit the unutilized amount in a Capital Gains Account Scheme (CGAS) with a notified bank.
Key Points
- The deposited amount should be utilized within the prescribed period for purchasing or constructing the specified asset.
- If the amount remains unutilized beyond the stipulated period, it is treated as capital gains in the year in which the period expires.
Limitations on Exemptions
- The aggregate amount of exemption cannot exceed the quantum of capital gains earned.
- If the specified assets are transferred before the completion of the lock-in period, the exemption claimed is withdrawn, and the previously exempted capital gains become taxable in the year of violation.
Importance of Documentary Evidence
For claiming exemptions, the assessee must maintain proper documentation, including sale deeds, purchase agreements, investment proofs, and deposit receipts under CGAS. These records are essential for verification during tax assessments.
Judicial Pronouncements on Capital Gains Exemptions
Several judicial decisions have shaped the interpretation and applicability of capital gains exemptions:
- In cases where the assessee fails to complete the construction of a residential house within the stipulated time, courts have provided relief if there is evidence of investment within the required period.
- Courts have also clarified that mere non-registration of a new property within the due date does not disqualify the assessee from claiming exemption if the investment is otherwise substantiated.
Planning Tips for Taxpayers
- Plan asset sales to ensure reinvestments align with exemption deadlines.
- Utilize CGAS if reinvestment within the stipulated time frame is uncertain.
- Ensure compliance with all documentary requirements.
- Consult tax advisors when claiming exemptions under complex provisions like Section 54GB.
Strategic Importance of Capital Gains Exemptions
Capital gains exemptions serve as an effective tool for taxpayers to defer or eliminate tax liabilities arising from asset sales. They also promote investments in infrastructure, residential housing, and entrepreneurial ventures, aligning individual financial planning with broader economic objectives.
Conclusion
Capital Gains Tax in India is a pivotal element of the income tax framework, designed to tax profits arising from the transfer of capital assets. The provisions governing capital gains are intricate, encompassing a broad spectrum of assets such as real estate, shares, mutual funds, gold, and other valuable properties. Understanding the nuances of asset classification, computation methods, and available exemptions is essential for accurate tax compliance and effective financial planning.
The fundamental trigger for capital gains taxation is the “transfer” of a capital asset. However, not all transfers attract tax liability, as numerous transactions like gifts, inheritances, partition of HUFs, and certain corporate restructurings are specifically excluded. Further, the distinction between short-term and long-term capital assets significantly influences the tax rates and computation approach, with long-term gains often enjoying benefits such as indexation.
The computation of capital gains involves meticulous consideration of the sale consideration, cost of acquisition, cost of improvement, and transfer-related expenses. Special rules govern cases involving inherited assets, depreciable assets, bonus shares, dematerialized securities, compulsory acquisitions, and specific corporate actions like buy-backs or conversions. Deemed transfers and notional considerations under sections like 50C, 50CA, and 45(5A) ensure that capital gains are taxed even in scenarios where actual monetary consideration might be ambiguous or underreported.
Exemptions under Sections 54 to 54GB play a vital role in providing relief from capital gains taxation. These provisions incentivize taxpayers to reinvest gains in residential properties, agricultural lands, specified bonds, or business ventures, thus promoting asset reinvestment and entrepreneurial growth. The Capital Gains Account Scheme further facilitates tax deferral for individuals who require extended time to execute their reinvestment plans.
For taxpayers, the strategic management of capital gains involves not only understanding the statutory provisions but also aligning transactions with exemption opportunities. Proper documentation, adherence to timelines, and awareness of judicial interpretations are crucial to safeguard claims of exemption and to optimize tax liabilities.
In summary, while capital gains taxation is inherently complex, it offers ample opportunities for tax efficiency through lawful planning. Individuals and businesses alike should approach capital gains transactions with a comprehensive understanding of legal provisions, ensuring that every step from acquisition to reinvestment is meticulously planned to minimize tax impact and maximize financial benefits.