Understanding Section 45 of the Income Tax Act

Section 45 of the Income-tax Act, 1961, is the charging section for capital gains, establishing the liability to pay tax on income generated from capital gains. This provision defines the scope and conditions under which such gains are taxable. In this article, we will discuss the chargeability of capital gains in detail.

Budget 2025 Update

• It is proposed to include ULIPs with premiums exceeding 10% of the policy’s sum assured, alongside those with annual premiums above Rs. 2.5 lakh.
• It is proposed to amend Section 2(14) to clarify that securities held by investment funds under Section 115UB, will be treated as capital assets

Overview of Section 45

Section 45 of the Income Tax Act, 1961, governs income tax on capital gains arising from transferring a capital asset. It provides that any profits or gains arising from the transfer of capital assets shall be chargeable under the head capital gains in the year in which the transfer took place.

Important Terms to Understand

1. Definition of Capital Assets: A capital asset includes property of any kind held by an individual, whether or not connected with their business or profession. It also consists of any securities held by a Foreign Institutional Investor (FII). Still, it excludes stock-in-trade, personal effects (excluding jewellery, paintings, etc.), agricultural land in rural areas, and certain specified bonds.
2. Types of Capital Gains
   • Short-Term Capital Gains (STCG): These gains arise from the transfer of a capital asset held for 36 months or less. However, the holding period is reduced to 12 months for financial assets like listed shares and securities and less than 24 months for unlisted shares and immovable property.
   • Long-Term Capital Gains (LTCG): These gains arise from the transfer of a capital asset held for more than 36 months. However, the holding period for listed shares and securities should exceed 12 months, while for unlisted shares and immovable property, it should exceed 24 months.
3. Computation of Capital Gains: The computation of capital gains involves several steps:
   • Full Value of Consideration: This is the consideration received or accruing from the transfer of the capital asset.
   • Cost of Acquisition: The price at which the capital asset was acquired.
   • Cost of Improvement: Expenses incurred in making any improvements to the asset.
   • Expenditure on Transfer: Expenses directly connected to the transfer of the asset.
4. The capital gains are computed as follows:

• Short-Term Capital Gains (STCG) 

STCG=Full Value of Consideration−Cost of Acquisition−Cost of Improvement−Expenditure on Transfer

• Long-Term Capital Gains (LTCG): 

LTCG=Full Value of Consideration−Indexed Cost of Acquisition−Indexed Cost of Improvement−Expenditure on Transfer

The concept of indexing is applied to adjust the cost of acquisition and improvement according to the government-notified Cost Inflation Index (CII), which accounts for inflation over the years.

Exemptions and Reliefs Under Section 45

The Income Tax Act provides various exemptions and reliefs to reduce the tax burden on capital gains. Some significant exemptions are:

1. Section 54: This section contains an exception to the capital gains realised from the sale of an investment property if the gains are used to acquire or develop another investment property within the prescribed periods.
2. Section 54F: It permits exemption on capital gains on the sale of any property other than residential house property, on the condition that the net consideration is used to purchase a new residential house.
3. Section 54EC: This section allows capital gains tax exemption on the earned profits if used for the purchase of bonds, including NHAI or REC bonds, within six months of the sale.
4. Section 54B: It offers an exception to the gains that result from the sale of agricultural land, on condition that they are used to buy another piece of agricultural land within two years.

Click here to learn more about the exemptions available for Capital gains.

Special Provisions Under Section 45

1. Compulsory Acquisition: Where a capital asset is transferred by way of compulsory acquisition under any law, the capital gains arising from such acquisition are taxable in the previous year in which the compensation or any part thereof is received.
2. Conversion of Capital Asset into Stock-in-Trade: When a capital asset is converted into stock-in-trade of a business, the capital gains are taxed when the stock-in-trade is sold. The fair market value in the conversion date is considered as the total value of consideration.
3. Insurance Compensation: Where a capital asset is destroyed, and the amount is received in cash, being the insurance compensation in respect of such capital asset, the capital gain is deemed to be computed and taxed in the year in which such compensation is received.
4. Joint Development Agreements: Where an assessee enters into a joint development agreement, the income in the form of capital gains is taxable in the year in which the competent authority issues a certificate that the whole or any part of the project having regard to the contract note or the agreement executed by the joint development agency has been completed.

Implications of Non-Compliance

Failure to meet the provision of Section 45 attracts severe penalties for any information given and attracts interest. Taxpayers have to be very certain when filing their capital gains tax and have to make sure that they are able to pay the amount stated at the correct time so that they do not have to face legal charges. Revenue departments like the Income Tax Department have strict measures that incorporate the identification of and penalties for any anomalies or attempts at evasion.

Practical Considerations

1. Documentation: Accurate computation and reporting of capital gains entitle the right documentation of all manner of transactions relating to capital assets, such as purchasing invoices, receipts for improving capital assets, and selling agreements.
2. Professional Advice: Given the complexities involved in computing capital gains and the various exemptions available, it is advisable to seek professional advice. Chartered accountants or tax consultants can provide valuable guidance and ensure compliance with tax laws.
3. Investment Planning: Effective investment planning can help in optimising tax liabilities. For instance, timing the sale of assets to qualify for long-term capital gains tax rates or availing of exemptions by reinvesting in specified assets can result in significant tax savings.

Conclusion

Section 45 of the Income Tax Act of India plays a very important role in the process of taxing capital gains. Therefore, taxpayers must grasp its complexities, including the instances when it applies, other forms of exceptions, and the conditions that need to be met for compliance. There are ways or measures in place in which one can manage taxes resulting from capital gains, including documentation, seeking professional advice, and making appropriate investment decisions.