1. Introduction

Budget 2018 proposed to remove Section 10 (38) of the Income Tax Act, 1961. As per this section, the long-term capital gains (LTCG) arising on sale of equity shares or units of an equity-oriented mutual fund on which Securities Transaction Tax (STT) is paid was exempt from taxation. This section was initially introduced through the Finance Act, 2004, with effect from AY 2005-06, based on the Kelkar Committee report to attract investments from Foreign Institutional Investors (FII). However, short-term capital gains (STCG) on the transfer of equity shares or units of an equity-oriented mutual fund on which Securities Transaction Tax (STT) is paid, is taxable at the rate of 15%.

The taxation rules with respect to LTCG and STCG on business trusts, i.e. Real Estate Investment Trust (ReIT) and Infrastructure Investment Trust (InvIT) are similar to what has been stated above.

2. Proposal of introduction of Section 112A

The Budget 2018 introduced Section 112A by withdrawing Section 10(38). It proposed to impose tax on the LTCG of the following:

a. Shares,

b. Equity-oriented funds or

c. Business trusts

The LTCG tax is applicable at a rate of 10% on gains over and above Rs 1 lakh a year, and there is no benefit of indexation.

3. Applicability

The provisions of this section will apply from the financial year (FY) 2018-19, i.e. AY 2019-20. This otherwise means any transfer carried out after 1 April 2018, resulting in LTCG above Rs 1 lakh, will attract tax at the rate of 10%.

4. Proposal to grandfather investments made upto 31 January 2018

In the budget, there has been a proposal to grandfather investments made on or before 31 January 2018.

What is the concept of Grandfathering?

When a new clause or policy is added to a law, certain persons may be relieved from complying with the new clause. This is called “grandfathering”.
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“Grandfathered” persons enjoy the right to avail concession because they have made their decisions under the old law. The concept of grandfathering in the case of LTCG on sale of equity investments works as follows:  

The concept of grandfathering in the case of LTCG on sale of equity investments works as follows

A method of determining the Cost of Acquisition (COA) of such investments have been specifically laid down as per the COA of such investments shall be deemed to be the higher of:

1. The actual COA of such investments; and
2. The lower of-
   • Fair Market Value (‘FMV’) of such investments; and
   • the Full Value of Consideration received or accruing as a result of the transfer of the capital asset i.e. the Sale Price

Further, the FMV would be the highest price quoted on the recognised stock exchange on 31 January 2018. In case there is no trading of the said asset in such stock exchange, the highest price on a day immediately preceding 31 January 2018 shall be considered to be the FMV. In effect, the taxpayer can claim the highest price quoted on the recognised stock exchange on 31 January 2018 as the COA and claim the deduction for the same.

The computation mechanism has been further explained by way of the following examples

Capital Gain/ Loss = Sale Price – Revised Cost of   Acquisition on 31.1.2018

Example 1

Mr X bought equity shares on 15/Dec/2016 for Rs. 10,000. FMV of the shares was Rs. 12,000 as on 31/Jan/18. He sold the shares on 10/May/2018 for Rs. 15,000. What will be the long-term capital gain/ loss?

Cost of Acquisition (COA)

Higher of –

• Original COA i.e. Rs. 10,000, and  
• Lower of –
  • FMV on 31.1.18 i.e. Rs. 12,000, and
  • Sale Price i.e. Rs. 15,000

Hence, COA = Higher of (Rs. 10,000 or Rs. 12,000) = Rs. 12,000

Capital Gain/ (Loss)

• Sale Price – Cost of Acquisition
• Rs. 15,000 – Rs. 12,000
• Rs. 3,000

Example 2

Mr. A purchased equity shares on 20/Jan/2017 for Rs. 16,000. FMV of the shares was Rs. 11,000 as on 31/Jan/18. He sold the shares on 26/Apr/2018 for Rs. 26,000. What will be the long-term capital gain/ loss?

Cost of Acquisition (COA)

Higher of –

• Original COA i.e. Rs. 16,000, and  
• Lower of –
  • FMV on 31.1.18 i.e. Rs. 11,000, and
  • Sale Price i.e. Rs. 26,000

Hence, COA = Higher of (Rs. 16,000 or Rs. 11,000) = Rs. 16,000

Capital Gain/ (Loss)

• Sale Price – Cost of Acquisition
• Rs. 26,000 – Rs. 16,000
• Rs. 10,000

Example 3

Mr. D bought equity shares on 11-Nov-2016 for Rs. 19,500. FMV of the shares was Rs. 12,000 as on 31-Jan-18. He sold the shares on 21-May-2018 for Rs. 9,000. What will be the long-term capital gain/ loss?

Cost of Acquisition (COA)

Higher of –

• Original COA i.e. Rs. 19,500, and  
• Lower of –
  • FMV on 31.1.18 i.e. Rs. 12,000, and
  • Sale Price i.e. Rs. 9,000

Hence, COA = Higher of (Rs. 19,500 or Rs. 9,000) = Rs. 19,500

Capital Gain/ (Loss)

• Sale Price – Cost of Acquisition
• Rs. 9,000 – Rs. 19,500
• Rs. (10,500)

Example 4

Mr. D bought equity shares on 23/Oct/2016 for Rs. 14,500. FMV of the shares was Rs. 18,000 as on 31/Jan/18. He sold the shares on 18/May/2018 for Rs. 7,000. What will be the long-term capital gain/ loss?

Cost of Acquisition (COA)

Higher of –

• Original COA i.e. Rs. 14,500, and  
• Lower of –
  • FMV on 31.1.18 i.e. Rs. 18,000, and
  • Sale Price i.e. Rs. 7,000

Hence, COA = Higher of (Rs. 14,500 or Rs. 7,000) = Rs. 14,500

Capital Gain/ (Loss)

• Sale Price – Cost of Acquisition
• Rs. 7,000 – Rs. 14,500
• Rs. (7,500)

Given below is further analysis of the LTCG implications of certain other scenarios which will help understand the proposed amendment better:

Note: The above table has been prepared with a presumption that all gains are long term.

5. LTCG on transfer of bonus and rights shares acquired on or before 31 January 2018

TThe LTCG for these shares shall be calculated by considering the FMV on 31 January 2018 as the COA of such shares thereby exempting gains until 31 January 2018 from tax.

6. Carry forward of Long-Term Capital Losses (“LTCL”) on sale of such shares

The income tax department has vided its FAQs dated 4 February 2018 and clarified that LTCL resulting from a transfer made on or after 1 April 2018 will be allowed to set-off and carried forward under the existing provisions of the Act. Therefore, it can be set-off against any other LTCGs and unabsorbed LTCL can be carried forward to subsequent eight years for set-off against LTCG.

7. Rebate under 87A

There is also a proposal to allow the deduction under Section 87A of the Income Tax Act on income tax computed on all income, excluding the income tax payable on such LTCG.

8. Our Take

To compensate for the shortfall in the GST collection, the government has probably taken this step of imposing a levy of taxes on shares held for the long-term. This is of course, over and above the already existing Securities Transaction Tax (STT) which was introduced in the year 2004 to check instances of capital gains tax evasion.

Overall, the levy of both LTCG tax and STT seems quite unfair. The main question remains unanswered: “How far this move will contribute to yielding a higher revenue to the government, which is the underlying objective of this move?”