The Hindu Business Line : An anomaly that needs rectification

PRESENTING the 2004 Budget, the Finance Minister, Mr P. Chidambaram, characterised the capital gains tax as a vexed issue getting more complex when applied to capital market transactions. As a first move toward revamping taxes on securities transactions, he proposed a tax on securities sold on recognised stock exchanges, and reducing/eliminating the tax on capital gains realised on such sales.

Eventually, the Finance (No. 2) Act, 2004, modified the proposal by reducing the rate of the transactions tax, and confining the tax benefit to gains from equity shares of companies or units of equity-oriented mutual funds.

Consequently, capital gains on such financial assets are now taxed at 10 per cent if the gains are short-term (see the new Section 111A of the Income-Tax Act, 1961), and are not taxed if the gains are long-term (see the new Section 10(38) of the Act). In either case, to be eligible for the tax benefit, the transactions should have been effected on or after October 1, 2004, and be chargeable to the Securities Transaction Tax.

Capital gains on securities not falling within Sections 10(38) or 111A are taxed at varying rates. Short-term gains are deemed to be income of the year in which the sale took place, and included in the total taxable income. Depending upon the slab in which an assessee's total taxable income falls, these gains may attract the highest rate of tax (currently, about 33 per cent, including a surcharge and cess).

If the capital gains are long-term, these are generally taxed at 20 per cent with the cost of acquisition of the asset adjusted for inflation (by applying the government-announced annual cost-inflation index), and at no higher than 10 per cent (without being cost-adjusted) of the gains in the case of specified securities (that is, those listed on recognised stock exchanges, mutual-fund units, or zero coupon bonds).

The tax on long-term capital gains can be avoided if the gains are reinvested in specified financial assets under Sections 54EC or 54ED, or in residential houses under Section 54F, subject to the fulfilment of specified conditions.

The 2004 tax concession has imparted a further push to an already rising stock market. However, it has also introduced a few avoidable complications in the tax structure, especially on the set-off between capital gains or losses and the carry-over of unadjusted net losses. A streamlining of the tax regime in this regard seems necessary.

The recent lenient and differential treatment of capital gains on equity shares and equity-oriented units of mutual funds has led to a division of financial assets into two broad categories for the purpose of reckoning and taxing the capital gains or losses on transfer of such assets: i) equity shares of companies and units of equity-oriented mutual funds the sales of which (on or after October 1, 2004) are subject to the Securities Transaction Tax; and ii) others.

The second, residual, category includes equity shares sold outside of recognised stock exchanges, preference shares, debt instruments of various types (for example, debentures and bonds, units of debt-oriented funds or mixed funds in which the equity component is less than 51 per cent of the total net invested assets), and equity shares of foreign companies and equity-oriented units of overseas mutual funds.

Within each of these two categories, the taxation of capital gains varies with the period for which the assets were held before the transfer. Thus, financial assets may be broadly classified into four categories for purposes of capital gains taxation (see Table).

In terms of Section 70(2) of the I-T Act, an assessee is entitled to set off a loss on the transfer of a short-term capital asset computed under Sections 48-55 of the Act against the capital gains on any other capital asset arrived at under a similar computation. Thus, short-term capital losses computed under Sections 48-55 can be set off against short- or long-term capital gains computed under the same sections.

Under Section 70(3) of the Act, an assessee can only set off a loss on the transfer of a long-term capital asset computed under Sections 48-55 against the capital gain on any other long-term capital asset arrived at under a similar computation.

The material criterion for set-off of short-term capital losses against any other capital gains (whether on short- or long-term capital assets) and of long-term capital losses against long-term capital gains as noted above is "similar computation" of the losses and gains. It is immaterial that the gains to be adjusted are not taxable at a "similar (or the same) rate of taxation" as that which would have applied had the transfer in question resulted in a gain instead of a loss.

Thus, if the losses/gains have been calculated on the same basis, then there can be an adjustment as permitted by the statute, regardless of the rate of tax applicable to the gains to be so set off. If the basis of computation is different, then there cannot be a set-off, whatever be the rate of taxation applicable to the gains to be set off.

In some cases, such as gains on transfers of certain long-term capital assets, including financial assets (other than bonds or debentures excluding capital-indexed Government of India bonds, and shares or debentures of an Indian company acquired in foreign currency and transferred by a non-resident assessee), Section 48 of the Act requires the acquisition cost of the asset to be taken at its inflation-adjusted value by applying the cost-inflation index (CII) to the historical cost, instead of at the historical cost itself.

Under Section 112, long-term capital gains, calculated on the basis of the inflation-adjusted cost of the transferred assets, are generally taxable at 20 per cent of the gains. However, the proviso under Section 112(1)(d) limits the tax to 10 per cent on long-term gains made on listed securities, units of mutual funds, or specified zero-coupon bonds.

One may interpret the provisions of Sections 70(2) and 70(3) of the Act to the effect that where the losses in question have been computed on the basis of the historical cost of the asset and the gains to be offset are based on their inflation-adjusted cost, there can be no set-off.

Conversely, where the losses are reckoned on the basis of the inflation-adjusted cost and the gains to be offset have been arrived at on the basis of the historical cost, there can be no set-off. In such cases, there is no "similar computation" of the losses and the gains.

Corresponding to the provisions of Section 70, Section 74 requires that the net loss on a short-term capital asset be set off against capital gains on any other capital asset (short or long term) during the year.

However, the net loss on a long-term capital asset shall only be set off against the capital gains on a long-term capital asset. Any loss that cannot be so adjusted, whether on short- or long-term assets, can be carried forward for up to eight more assessment years.

Before the amendment to Sections 70 and 74 by the Finance Act, 2002, capital losses, whether on short- or long-term assets, could be set off against capital gains on short- or long-term assets, and the net unadjusted loss could be carried forward for eight more years. According to the official explanatory memorandum on the related Finance Bill, the amendment was aimed at eliminating the anomaly inherent in the earlier tax regime that allowed long-term capital gains, which attracted (and continue to attract) a lower incidence of tax than short-term capital gains, to be adjusted against short-term capital losses as well as long-term capital losses.

A vital distinction, for the purpose of adjustment of losses against gains, was thus made on the basis of the tax incidence on the gains. This differentiation seems quite logical.

However, the introduction in 2004 of concessive tax treatment of capital gains on financial assets, such as listed securities transferred on stock exchanges on payment of the securities transaction tax, and units of equity-oriented mutual funds, has reintroduced the same anomaly that the Finance Act 2002 sought to remove. Taxation of capital gains on short-term or long-term financial assets varies depending upon whether or not they meet the criteria for concessive tax treatment, under either Section 10(38) or 111A.

As shown above, short-term capital gains are divided into two broad categories for the purpose of taxation. So also, long-term capital gains. However, short-term capital losses on financial assets can be offset against short-term capital gains on other assets, even though short-term capital gains on financial assets similar to those transferred would attract a lower rate of taxation.

Also, long-term capital losses on financial assets can be offset against long-term capital gains on other assets, although there would have been no tax at all had the assets in question generated a capital gain instead of a loss.

This anomaly needs rectification. Any adjustment of losses and gains should only be allowed if the assets are of the same category, with the gains thereon attracting the same rate of taxation. The current distinction based on the mode or basis of computation of the gains would then cease to be relevant.

A logical extension of such a change in law would be that carry-over of unadjusted net loss would be related to the rate of taxation on such assets and not merely to whether they are short or long term.

Thus, net unadjusted losses on long-term capital assets, the long-term gains on which would have been tax-exempt, would not be allowed to be carried forward so long as any gains on such assets are tax exempt. Net unadjusted losses on long-term capital assets, the capital gains on which are subject to tax at 10 per cent (where the cost is not inflation-adjusted) or 20 per cent (where inflation-adjusted), should be required to be carried forward separately.

Similarly, net unadjusted short-term capital losses on assets, the short-term capital gains on which would have been included in the taxable income, would be carried forward separately, as distinct from net unadjusted short-term capital losses on assets that fall within Section 10(38) and attract just a 10 per cent tax on their capital gains.

(The author is a freelance writer on finance and law.)

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