COMPENDIUM OF PLANNING FOR CAPITAL GAINS GUIDING THE SAVINGS IN THE TAX INCIDENCE

Submitted: Prof. to Ashok Shelat

Submitted by: Digesh C. Shah Roll No.:- 29 Subject: Tax Laws F.M.S.-B (MSU) (2009-11)

What are Capital gains?

A capital gain is a profit that results from investments into a capital asset, such as stocks, bonds or real estate, which exceeds the purchase price. It is the difference between a higher selling price and a lower purchase price, resulting in a financial gain for the investor. Conversely, a capital loss arises if the proceeds from the sale of a capital asset are less than the purchase price.

Definition as given in Taxmann is “Any gain arising on the transfer [except such transfers as are given in section 46 and 47] of a capital asset [sec. 2(14)] is chargeable to tax under section 45, if it is not eligible for exemption under sections 54, 54B, 54D, 54EC, 54F, 54G, 54GA and 54H.”

Capital gains may refer to "investment income" that arises in relation to real assets, such as property; financial assets, such as shares/stocks or bonds; and intangible assets such as goodwill.

"Capital gains" tax is really a misnomer. It would be more appropriate to call it the "capital formation" tax. It is a tax penalty imposed on productivity, investment, and capital accumulation.

The capital gains tax is different from almost all other forms of taxation in that it is a voluntary tax. Since the tax is paid only when an asset is sold, taxpayers can legally avoid payment by holding on to their assets--a phenomenon known as the "lock-in effect."

Many countries, like India, impose a tax on capital gains of individuals or corporations, although relief may be available to exempt capital gains: in relation to holdings in certain assets such as significant common stock holdings, to provide incentives for entrepreneurship, or to compensate for the effects of inflation.

What are capital assets?

Capital assets include all moveable or immoveable property which is normally held for long-term and cannot be converted into cash easily. Hence, capital assets do not include trading goods, gold bonds, personal effects excluding jewelry, and agricultural land not falling within limits of any notified municipal area. Examples of capital assets are: land, building, plant and machinery, shares, debentures, units of mutual funds etc.

Assets not treated as “capital asset”Exception 1

Any stock-in trade, consumable stores or raw material held for the purposes of business or profession.

Exception 2

Personal effects of the assessee, i.e. movable property including wearing apparel and furniture held for his personal use.

Exception 3

Agricultural land in India provided it is not situated-a. in any area within jurisdiction of municipality or a cantonment board,

having population of 10,000 or more.b. in any notified area.

Exception 4

6½ percent Gold Bonds, 1977 or 7 percent Gold Bonds, 1980 or National Defence Gold Bonds, 1980 issued by the Central Government.

Exception 5

Special Bearer Bonds, 1991.

Exception 6

Gold Deposit Bonds issued under Gold Deposit Scheme, 1999.

The under mentioned assets is brought under the scope of capital assets and has been excluded from the scope of personal effects:

Archeological collections Paintings Drawings Sculptures Any work of art

What are Long Term and Short Term capital assets?Capital assets are classified as Long Term or Short Term with reference to the period of holding of the assets till it is transferred. The classification is made on the following basis:-

Nature of asset Short term capital asset Long term capital asset(i) Shares in a company or any other security listed in a recognised stock exchange in India or a unit of a Unit Trust of India or a  unit of a mutual fund specified under section 10(23D).

Held for not more than 12 months.

Held for more than 12 months.

(ii) Assets other than assets mentioned in (i) above. 

Held for not more than 36 months.

Held for more than 36 months.

Section 2(14) defines capital assets as follows:

"2. (14) 'capital asset' means property of any kind held by an assessee, whether or not connected with his business or profession, but does not include—(i) any stock-in-trade, consumable stores or raw materials held for the purposes of his business or profession;(ii) personal effects, that is to say, movable property (including wearing apparel and furniture, but excluding jewellery) held for personal use by the assessee or any member of his family dependent on him".

Long Term Capital Gain

Gain arising from sale of capital assets like shares after a period of one year is known as long-term capital gain tax. In India, long term capital gain is exempt from tax.

Exemptions from Long Term Capital Gain TaxIn case of Individuals and HUF, long-term capital gains are exempt if the sale proceeds are reinvested in certain assets.

Some examples:1. Profits on sale of residential house are reinvested in a new residential house2. Long term capital gains are invested in notified bonds

These exemptions are subject to certain conditions and the reinvestment has to be made within the prescribed time.

Short Term Capital GainAny profit/gain arising out of sale of capital assets (like shares etc.) before a period of one year is known as short-term capital gain. Short-term capital gains are taxable at the rate of 10%.

Ceiling prescribed for investment in Long-Term Specified Bonds (LTSB) for claiming the exemption of long-term capital gains:

All the capital gains arising from transfer of any long-term capital assets is exempt if such gains are invested in Long-Term Specified Bonds. From April 1, 2007, ceiling of Rs 5 million has been stipulated for investments in such bonds made during any financial year.

Notifying of such bonds in Official Gazette is dispensed. Bond issued by NHAI or by REC on or after 01.04.07 & redeemable after three years will be LTSB. Bond issued between 01.04.06 & 31.03.07 will be deemed to be LTSB.

Short-term Capital gains tax

Long-term Capital gains tax

Sale transactions of securities which attracts Securities Transaction Tax (STT):-

10% NIL

Sale transactions of securities not attracting STT:-Individuals (resident and non-residents)

Progressive slab rates 20% with indexation;10% without indexation (for units/ zero coupon bonds)

Partnerships (resident andnon-resident)

30%

Individuals (resident and non-residents)

30%

Overseas financial organizations specified in section 115AB

40% (corporate)30% (non-corporate)

10%

FIIs 30% 10%Other Foreign companies 40% 20% with indexation;

10% without indexation (for units/ zero coupon bonds)

Local authority 30%Co-operative society Progressive slab rates

How is capital gain computed?Subject to certain exceptions, capital gain is computed in the following manner:- Capital gains can be computed by using the below mentioned formula:

Note: In case of long term capital assets, costs are adjusted as per cost inflation index for the year.

Capital Gain = ( Full value of consideration received or accrued on transfer of capital asset) - ( Cost of acquisition of capital assets + Cost of improvement of capital assets + Expenditure incurred wholly and exclusively in connection with the transfer of capital asset such as stamp duty, registration charges, legal fees, brokerage etc.)

In respect of long term capital assets, cost of acquisition and cost of improvement should be worked out as under:-

The cost inflation index is notified by the Central Govt. for every year and it is given on Tax information page of this site.

What is unearned income?

Unearned income refers to income that is not a wage.

It includes interest, dividends or realized capital gains from investments, rent from land or property ownership, and any other income that does not derive from work.

Unearned income has often been treated differently for tax purposes than earned income, in order to redistribute income or to recognize its qualitative difference from income derived from work. Such a tax structure is most often associated with a progressive income tax structure.

In recent times the pendulum has swung the other way, and most western countries tax unearned income more favourably than income from work.

Some economists claim that unearned income is compensation for deferring consumption, freeing up those resources to be invested in improving the future, by funding research and development of new technologies and services, capital equipment

and education to improve the productivity of labor and so forth. This view also holds that unearned income provides an incentive to save, and capital markets facilitate allocation of resources to those enterprises which will provide the best economic benefit. Extra taxes on unearned income can interfere with these mechanisms. This point of view also asserts that all income is ultimately earned, and ask why tax should be higher on work that was done 100 years ago than work that is done today.

How are capital gains on bonus shares to be computed?

The cost of bonus shares is to be taken as Nil and the net sale proceeds of the bonus shares is to be treated as the capital gains. The period of holding of the bonus shares will be counted from the date of the allotment of bonus issue.

How is tax on Short Term Capital Gains to be computed ?

Short term capital gains are taxed in the same manner as income under other heads. Barring certain exceptions, long term capital gains are taxed at the flat rate of 20%.

Tax on long-term capital gains.(1) Where the total income of an assessee includes any income, arising from the transfer of a long-term capital asset, which is chargeable under the head “Capital gains”, the tax payable by the assessee on the total income shall be the aggregate of,—

(a) in the case of an individual or a Hindu undivided family, [being a resident,]—

(i) the amount of income-tax payable on the total income as reduced by the amount of such long-term capital gains, had the total income as so reduced been his total income ; and

(ii) the amount of income-tax calculated on such long-term capital gains at the rate of twenty per cent :

Provided that where the total income as reduced by such long-term capital gains is below the maximum amount which is not chargeable to income-tax, then, such long-term capital gains shall be reduced by the amount by which the total income as so reduced falls short of the maximum amount which is not chargeable to income-tax and the tax on the balance of such long-term capital gains shall be computed at the rate of twenty per cent ;

(b) in the case of a [domestic] company,—

(i) the amount of income-tax payable on the total income as reduced by the amount of such long-term capital gains, had the total income as so reduced been its total income ; and

(ii) the amount of income-tax calculated on such long-term capital gains at the rate of [twenty] per cent :

[***]

[(c) in the case of a non-resident (not being a company) or a foreign company,—

(i) the amount of income-tax payable on the total income as reduced by the amount of such long-term capital gains, had the total income as so reduced been its total income ; and

(ii) the amount of income-tax calculated on such long-term capital gains at the rate of twenty per cent ;]

[(d)]in any other case [of a resident],—

(i) the amount of income-tax payable on the total income as reduced by the amount of long-term capital gains, had the total income as so reduced been its total income ; and

(ii) the amount of income-tax calculated on such long-term capital gains at the rate of [twenty] per cent.

[Provided that where the tax payable in respect of any income arising from the transfer of a long-term capital asset, being listed securities [or unit] [or zero coupon bond], exceeds ten per cent of the amount of capital gains before giving effect to the provisions of the second proviso to section 48, then, such excess shall be ignored for the purpose of computing the tax payable by the assessee.

[Explanation.—For the purposes of this sub-section,—

(a) “listed securities” means the securities—

(i) as defined in clause (h) of section 2 of the Securities Contracts (Regulation) Act, 1956 (32 of 1956); and

(ii) listed in any recognized stock exchange in India;

(b) “unit” shall have the meaning assigned to it in clause (b) of Explanation to section 115AB.]]

(2) Where the gross total income of an assessee includes any income arising from the transfer of a long-term capital asset, the gross total income shall be reduced by the amount of such income and the deduction under Chapter VI-A shall be allowed as if the gross total income as so reduced were the gross total income of the assessee.

(3) Where the total income of an assessee includes any income arising from the transfer of a long-term capital asset, the total income shall be reduced by the amount of such income and the rebate under section 88 shall be allowed from the income-tax on the total income as so reduced.

What are the exemptions available in respect of capital gains?

Depending upon the nature of the capital asset and the manner of utilisation of the consideration received on transfer, various exemptions are available. For full details, Sections 54, 54B, 54D, 54EA, 54EB, 54EC, 54F, 54G and 54H of the Income-tax Act may please be referred. The provision of 54EA and 54EB has been withdrawn with effect from 1.4.2000 and new section 54 EC has been inserted. Under Section 54EC investments should be made in: National Highways Authority of India & Rural Electrification Corporation Limited.

What is the Cost Inflation Index?

It is a measure of inflation that finds application in tax law, when computing long-term capital gains on sale of assets.

Is there a way to avoid paying capital gains tax after selling shares to buy a house?

People are always trying to find that magic way to not pay capital gains taxes.

After all, capital gains taxes don't seem all that fair. It was you, not the government, that researched stocks, picked a good investment and took the risk on it. If you hit it big on a stock, and earned a profit, it might not seem fair the government gets to piggyback on your skill or good fortune.

But that's the rule. When you sell an investment for more than you paid, you have what's called a capital gain. Capital gains are taxable in most cases. They're taxable whether you're going to use the capital gains to buy a car or a house.

Certainly, there are ways to manage your tax liabilities. For instance, if you have any stocks you're losing money on, you can sell them and use the capital losses to reduce your taxable capital gain. And a tax professional may be able to legally shift certain other forms of income to perhaps lower your overall tax bill. And for these reasons, if you have a large enough capital gain, it might be worth meeting with someone for ideas to manage the gain.

Additionally, there's talk of perhaps capital gains rates increasing in the future. If that's the case, you might be glad to pay the current capital gains rates for the current tax year.

But the bottom line is that capital gains are taxable

The more efficient fixed depositsThe elimination of section 80L also means that income from bank deposits, RBI (taxable) bonds and infrastructure bonds are now fully taxable. Mutual funds now look more attractive based on tax-adjusted returns.

Currently, debt-based mutual funds are required to pay an effective dividend distribution tax of 14.025 per cent (including the 10 per cent surcharge and 2 per cent cess). This income is tax-free in the hands of the investor. What about capital gains?

Units sold within one year qualify as short-term capital gains and are subject to tax at the marginal income-tax rate. Units sold after one-year attract long-term capital gains of 20 per cent plus a surcharge of 10 per cent and 2 per cent cess after availing of indexation benefits or a flat 10 per cent plus a surcharge of 10 per cent and 2 per cent cess.

Indexation is a relief provided by adjusting the return on which tax is calculated downward, to allow for reduced buying power of the saved amount due to inflation during the period of saving.

If you are looking for a fixed-income product with a holding period of less than one year, the dividend plans of debt mutual funds score over fixed-deposits, especially if you are in the highest tax slab. The tax incidence is half of what it is in other deposits.

However, most people fear mutual funds due to their volatility in returns. How does one avoid volatility in mutual funds? Rather, how does one ensure that you do not incur a capital loss and also a basic minimum return?

The answer lies in fixed maturity plans (FMPs) of mutual funds. These mutual funds work exactly like fixed-deposits. You get a pre-determined return based on current market yields, of course, after deducting fund management expenses which are lower than regular debt funds as there is less churning.

Fixed maturity plans demystifiedWhat is a fixed maturity plan?

A fixed maturity plan is an income scheme that allows saving only during the initial offer period that usually lasts from one day to one month and ceases to exist after a certain fixed duration. FMPs of one-month, three-month, one-year, three-year and five-year durations are periodically launched by mutual funds.

They provide an easy route to invest in different types of bonds - government securities, corporate bonds and money market instruments through mutual funds.

Saving in a fixed maturity plan is like knowing the exact day of harvesting a field on the day of planting the seeds. The harvest day is called the maturity date in the language of investments. Since saving in a fixed maturity plans is allowed only during their Initial Public Offering (IPO) period, and the savings are returned on the maturity date, these schemes are also called 'closed-ended schemes'. In contrast to these, saving in other 'open-ended schemes' is allowed throughout the existence of the scheme. Options available for withdrawal before the maturity date vary from scheme to scheme. These are specified in the offer document of the scheme.

What are the advantages of FMPs?

FMPs are popular because of their relative predictability. Their closed-ended nature allows fund managers to purchase bonds that pay back their investment on or around the maturity date and thus hold on to them till the end. This allows the fund to keep getting the agreed rate of interest on the bonds, effectively reducing what is called price risk (the potential for making a loss on bonds due to pressure to sell them off in the market). Though FMPs do not guarantee returns, a person who saves in an FMP has a fair idea of his indicative returns based on returns of similar duration bonds available in the market.

How do FMPs manage risks?

Debt investments are exposed to three broad kinds of risks:

Interest rate/price risk/re-investment risk Credit risk Liquidity

FMPs are able to mitigate most of the above risks by the very nature of their structure. They are less exposed to interest rate risk compared to other income schemes since

instruments therein are typically held till maturity and hence yield a fixed rate of return which is equal to the yield at which investments were made.

They also carry minimal liquidity risk as exit load is applicable for withdrawal before maturity. Hence, most investors withdraw only on the fixed maturity date of the scheme.

-- Standard Chartered Mutual Fund

Since they hold instruments till maturity, they also minimise expenses. As there is no regular churning of the portfolio, this significantly reduces the overall cost of transactions.

Investors with a time-horizon of more than one year can actually end up paying zero tax by using a trick called double indexation. Double indexation gives an investor the advantage of indexing his investment to inflation for two years while remaining invested for a period of slightly more than an year.

This can be done if the investor puts in his money just before the end of a financial year and withdraws it immediately after the end of the next financial year.

How double indexation reduces your tax outgoThe indexation table published by the income-tax authorities is a series of numbers for

every year from 1981-82 that reflects the impact of inflation. For example, let's see the use of double indexation for Rs 10,000 saved in a fixed maturity plan that opened on March 31, 1995, and returned Rs 11,000 on closing on April 1, 1996. Thus the yearly return on savings is 10 per cent.

Now the person who saved the money calculates tax payable at the end of the year in three steps.

Calculate the Inflation Index by dividing the Yearly Inflation Index corresponding to the ending financial year by the Yearly Inflation Index corresponding to the starting

financial year. For our example this will be 305/259 = 1.178. Multiply the amount invested with the Index. Thus, the amount invested will become

Rs 11,780. This gives you the amount that is to be used as the initial saving for calculating the gain on which tax is applicable.

Since the amount used as initial saving (Rs 11,780) has become higher than the amount returned (Rs 11,000), there is no gain on which tax can be applied. Thus, in our

example, no tax is applicable when double indexation benefit is claimed.

Key takeaway: Short-duration fixed maturity plans (dividend plan) are ideal for less than one year. Thirteen month FMPs are best alternatives for one-year bank deposits. Do not commit yourself to more than one year of FMP as you run the risk of tax policy changes mid-way.

If finance ministers start looking closely at FMPs, they may simply stop allowing indexation benefits for debt funds and that will make your calculation go awry.

Home is where there is no tax

Owning a house is imperative. Not just owning, but owning one on borrowed capital. The key change that the Budget has brought about is that there is no longer any cap on the amount of principal repaid on your housing loan for tax deduction.

Under section 88, the limit was Rs 20,000. So your principal repayment alone can constitute the entire Rs 1,00,000 eligible for deduction. The deduction on principal repayment is over and above the deduction already available on housing loan interest up to Rs 1,50,000.

To put it simply, monthly instalment of Rs 20,833 will be eligible for full deduction from your income if you have no other investments/expenses eligible for tax deduction.

For people who are paranoid about housing loans, you can derive solace from the fact that lowering your present debt is as good as saving for your future in the taxman's eye.

Actually, principal repayments can be a good alternative to savings. Since some part of your income as a salaried employee goes towards compulsory savings through your contribution to the employees provident fund, you can choose to simply reduce your debt burden to get tax breaks.

For those who thrive on borrowed money, there is no limit on the amount of deduction you can claim on the interest paid on loans taken for house property (after deducting rental income from the same) which is not self-occupied.

If the interest repaid is, say, Rs 5,00,000 in a particular year, this expense is fully deductible from your gross taxable income. So you actually end up paying no income-tax at all. Of course, you need to have a supplementary income to support your living expenses!

Currently, home loans rates are hovering around 8 per cent. If you are in the top tax bracket, your tax savings can be upto 30 per cent, meaning your effective cost of funds comes down to less than 6 per cent.

Key takeaway: Prepaying principal can be a good alternative to savings. People in the high income bracket can indulge in a second house to lower their tax burdens substantially.

Equity for the long haul

Another way to perk up your regular income is to invest a portion of your investments in equity-based dividend-yield schemes which invest in high-dividend paying stocks. By virtue of the fact that their stock price is low in comparison to the dividend they pay (that is what makes the dividend yield high), the stocks are less risky. Since these are equity-based schemes, the dividend paid by them is tax-free.

When you buy and sell units of equity funds you pay a securities transaction tax of 0.2 per cent as in the case of equities. Short-term capital gains are taxed at 10 per cent while long-term capital gains are fully exempt from tax.

Currently, there are three dividend-yield funds available in the market, one each from Birla Mutual, Principal PNB Mutual and Tata Mutual Fund.

Besides, equity linked savings schemes are also a must-invest proposition now. The fact that investment in ELSSs entails a tax saving of upto 30 per cent (if you are in the top bracket) is to say that you can buy equities at a 30 per cent discount or that you earn a 30 per cent return on day one of investing.

Thus, ELSS can be an excellent alternative to investing directly in stocks. The prudent way to invest in ELSS is to commit a regular amount every month towards purchasing units of ELSS rather than bunch investments and buy units towards the end of the year.

This will not only ease the burden towards the end of the year but also average out your cost of acquisition of shares since you would buy more units when the markets are high and less when the markets are low.

Key takeaway: ELSS is smarter than direct equity purchases for most people

How to save tax on capital gains:The tax on capital gains hurts more than normal income tax, since it comes into play when you encash your savings. Take Ravi Mathur’s case. Over the years, this 45-year-old executive regularly stashed away money in the stock markets for his retirement. Now, due to a medical crisis, he needs to sell part of his shareholding. To pay capital gains tax at this stage is particularly painful for him. All his life he has paid tax regularly on his salary; he thinks it’s unfair to tax him now when he’s encashing his savings.

Tax benefits for capital gains. On the upside, to some extent, the law recognises the fact that capital gains cannot be equated with normal income. Hence, long-term capital gains–that arise on the sale of an asset that has been held for three years or more–enjoy the following benefits, resulting in a lower incidence of tax:

Cost of acquisition. If the capital asset being sold was acquired before April 1, 1981, the assessee can substitute the actual cost of the asset with its fair market value as on April 1, 1981, if it is beneficial to do so.

Indexation. The assessee can further enhance the cost of acquisition–thus reducing her capital gains–by factoring in the cost inflation index for the year in which the asset is being sold.

Lower rate of tax. The rate of tax is only 20 per cent plus surcharge as compared with the normal rates of tax at 10, 20 and 30 per cent or 35 per cent with surcharge. Assessees enjoy another benefit in the case of long-term capital gains arising from the transfer of listed securities or units of the Unit Trust of India (UTI) and other mutual funds (in these cases, the asset is considered long-term if it is held for a year or more). If the tax payable at the rate of 20 per cent (plus surcharge) after claiming the benefits of indexation is more than the tax payable at 10 per cent (plus surcharge) without indexation, the tax payable is now to be restricted to 10 per cent (plus surcharge).

Benefits of indexation: Clearly, if during a year the assessee sells a number of shares, she would have to calculate her capital gains with and without indexation for each transaction, and then decide which method reduces her tax liability in that particular transaction. In fact, if she sells, say, 200 shares in two different lots of 100 each on July 10, 1999, and November 18, 1999, she could pay tax in the first instance with indexation, and in the second case without indexation, depending on which method will result in a lower tax liability.

Typically, the higher the cost of acquisition in relation to the resale value and the longer the period of holding, the more beneficial it is for an assessee to claim the benefits of indexation. Take for example two situations: Situation 1 in which 100 shares were bought for Rs 1,500 each in June 1994, and Situation 2 in which 100 shares were acquired as bonus shares in November 1991. In the first case, if the assessee sells her shares in December 1999, and claims the benefit of indexation, she would pay Rs 5,436 in taxes at the rate of 22 per cent, as opposed to Rs 11,000 in taxes at 11 per cent without indexation. In Situation 2, of course, the assessee cannot avail the benefits of indexation, since the cost of acquisition of the bonus shares is nil. Her tax liability without indexation at 11 per cent is, therefore, Rs 27,500

How Indexation Cuts Tax

This table assumes two situations: Situation 1 in which 100 shares of Hindustan Lever were bought for Rs 1,500 each in June 1994, and Situation 2 in which 100 shares were acquired as bonus shares in November 1991. If an assessee sells the shares in December 1999, her tax liability with and without indexation will be calculated as follows:

Without indexation

Situation 1 With

indexation

Situation 2

Sale price of 100 shares 2,50,000 2,50,000 2,50,000Cost of acquisition 1,50,000 NilIndexed cost of acquisition[ 1,50,000X 389/259]

- 2,25,290 Nil

Long-term capital gains 1,00,000 24,710 2,50,000Tax on gains @ 22 per cent - 5,436 -Tax on gains @ 11 per cent 11,000 - 27,500Figures in Rs     Note: surcharge has been taken at the rate of 10 per cent on the assumption that the assessee's total income is more than Rs 60,000.

Series of transactions. How do you compute the lowest capital gains tax liability for a series of sale transactions? Let’s explain this with an example, say, Mathur sells assets on April 15, July 8, October 17, December 15, December 20, January 4, 2000, March 13 and March 17. Assuming Mathur has other income above the threshold limit of Rs 50,000, let’s say the capital gains payable would be Rs 50,000 without indexation, and Rs 40,000 with indexation for assets sold on April 15; and so on. In this case, to ensure the lowest tax liability, Mathur should use the following steps:

Mathur’s Transactions:

Step 1. He should first consider those transactions that result in a capital loss after indexation. His total loss during the year after indexation adds up to Rs 1.1 lakh.

Step 2. He should then arrange his long-term gains in sequence by first taking those gains where indexation results in the maximum benefit.

Step 3. Mathur should then set off his indexed losses against the indexed gains. Thus, Rs 1.16 lakh (the sum total of the most beneficial gains in the table ‘Arranging Mathur’s Gains’, exclusive of the fourth gain of Rs 5,000) minus Rs 1.1 lakh, leaves Mathur with a gain of Rs 6,000.

Step 4. The question now arises whether Mathur should pay tax at 22 per cent or 11 per cent on the gains of Rs 6,000. On the face of it, since the gain has been calculated after indexation, the assessee should pay tax at 22 per cent. This amounts to Rs 1,320 in taxes

However, going by the strict interpretation of Section 112, in my opinion, one should calculate tax at 11 per cent on the gain of Rs 6,000 after scaling it up by taking away the benefit of indexation. This is because the law provides that the maximum tax payable is 11 per cent on gains without indexation. Hence, the tax at the rate of 22 per cent on Rs

6,000 (gains calculated after claiming the benefits of indexation) should be compared with the tax at the rate of 11 per cent on the non-indexed gains.

Now, the gain of Rs 6,000 is a part of the December 15 transaction (remember, we are setting off the losses in sequence against the capital gains that offer the maximum benefit of indexation) where the gains with indexation are Rs 56,000, and the gains without indexation are Rs 63,000. Therefore, Rs 6,000 should be scaled up by multiplying it by the capital gains without indexation (Rs 63,000) divided by the gains with indexation (Rs 56,000).

Rs 6,000 x( Rs 63,000/Rs 56,000 )  = Rs 6,750

The tax on Rs 6,750 at 11 per cent works out to Rs 742, and this is the amount Mathur should pay, and not Rs 1,320.

Step 5. Coming to Mathur’s December 12 transaction where the gains with and without indexation are the same, he should pay tax at 11 per cent on the gain of Rs 5,000, since he gets no benefits for indexing the gain. Mathur thus pays Rs 550 in tax on this transaction, and Rs 1,292 (Rs 742 plus Rs 550) on his total capital gains during the year. Assessees must, however, note that effective assessment year 2001-2002, the surcharge payable has been increased from 10 per cent to 15 per cent if their total income exceeds Rs 1.5 lakh.

Set-off. Importantly, capital gains (whether short-term or long-term) can be set off against capital losses (whether short-term or long-term) at the discretion of the assessee, and the sequence of the set off does not depend on the sequence of each gain/loss. It is also not necessary that long-term gains be set-off first against a long-term loss, and a short-term gain against a short-term loss. It is for the assessee to choose which gain can be set-off against which loss in a manner that minimises her tax incidence the most.

As a rule, the assessee should first choose to set-off short-term gains against capital losses. The losses should be the sum total of short-term losses, and the long-term losses should be calculated after claiming the benefits of indexation. This is because short-term gains are taxed at 33 per cent, and hence these should be set off first against the available losses. Of course, this does not apply in the case of assessees in the lowest tax bracket, since their gains would anyway be taxed at only 10 per cent.

Threshold limit: If the assessee’s other taxable income is within the threshold limit of Rs 50,000, her long-term gains would not be subject to any tax at all to the extent the gains are within the threshold limit. For instance, if an assessee, Avinash Tendulkar, had long-term capital gains of Rs 70,000 without indexation or Rs 55,000 with indexation, and other taxable income of Rs 20,000 in assessment year 2000-2001, his tax liability would be:

Other taxable income = Rs 20,000 Capital gains (after indexation) = Rs 55,000 Total income = Rs 75,000 Less income within threshold limit = (-) Rs 50,000 (Rs 20,000 adjusted against other income; Rs 30,000 adjusted against capital gains)

Income after adjustment = Rs 25,000

Tendulkar’s tax liability on Rs 25,000 would be Rs 5,500 at the rate of 22 per cent. However, in my opinion, going again by the strict interpretation of Section 112, tax should be calculated at 11 per cent on Rs 25,000 without claiming the benefit of indexation. Therefore:

Rs 25,000 x( Rs 70,000 (non-indexed)/Rs 55,000 (indexed) ) = Rs 31,818

Without claiming indexation, Tendulakar should thus pay Rs 3,500 in taxes (calculated at 11 per cent).

If, however, the assessee’s income, excluding capital gains, is more than the threshold of Rs 50,000, and there are no long-term losses against which the gains can be set off, then there is a formula to determine whether it would be beneficial to index the gains. If the non-indexed long-term gain is more than double the indexed gain, one should index the gains. For instance, if the non-indexed gain from a transaction is Rs 10 lakh, and the indexed gain is Rs 4 lakh, the assessee would benefit from indexation.

 If, however, the indexed gain was half the non-indexed gain, it wouldn’t make a difference whether the assessee decides on indexation. For instance, if the non-indexed gain was Rs 10 lakh, then tax payable at 11 per cent would be Rs 1.1 lakh, and if the indexed gain was Rs 5 lakh, the tax payable at 22 per cent would again be Rs 1.1 lakh. So it doesn’t really matter in this case if the assessee chooses to index her gains.

Bottom line: Assessees can make substantial savings on long-term capital gains tax by choosing whether to index it to pay tax at 22 per cent or pay 11 per cent tax without indexation. The choice depends on the unavailed threshold limit of Rs 50,000, the losses available for a set-off against the gains, and the extent to which indexation reduces the capital gains in each transaction.

Capital Gain and Loss Categories:

Capital gains and losses are divided between short-term and long-term, and there are other special categories.

The theory behind these rules is that you gather all the gains and losses within a single category to figure out the overall result for that category before combining the results with another category. For example, if you have both gains and losses in the short-term category, you'll combine them to find the net amount of short-term gain or loss. You can't mix categories until after you've worked out the net amount within each category. After that, if you have gain in one category and loss in another, you combine the two.

Holding period

For the most part, the categories of gain or loss are determined by your holding period for the asset you sold. (There are also some special categories for certain types of assets.) For stocks, your holding period is generally determined by the amount of time that elapses between the trade date of your purchase and the trade date of your sale.

But if you acquired your stock other than by purchase your holding period may relate to some earlier date. For example, if you receive additional stock as a result of a stock split, the new stock has the same holding period as the stock you already held.

There are three holding periods for capital assets sold:

Those held for one year or less are considered short-term and receive no preferred tax treatment. You'll simply pay taxes at your "normal" tax rate on those gains.

Those held for more than one year are considered long-term, and you will receive a tax break on the sale of those assets.

Those held for more than five years are considered "super-long-term" and are taxed at an even lower rate than long-term gains. But, there are restrictions about when the assets were purchased that vary depending on your tax bracket.

Investment and other

Some people are concerned that they cannot use capital losses from one source to offset capital gain from another source. Generally this is not a problem. For example, if you have a capital gain from selling your home (beyond the amount you can exclude), you can use a capital loss from a stock investment to reduce or eliminate that gain.

There is much unfairness imbedded in the current tax treatment of capital gains. One is that capital gains are not indexed for inflation: the seller pays tax not only on the real gain in purchasing power but also on the illusory gain attributable to inflation. The inflation penalty is one reason that, historically, capital gains have been taxed at lower rates than ordinary income. In fact, "most capital gains were not gains of real purchasing power at all, but simply represented the maintenance of principal in an inflationary world."

Another unfairness of the tax is that individuals are permitted to deduct only a portion of the capital losses that they incur, whereas they must pay taxes on all of the gains. That introduces an unfriendly bias in the tax code against risk taking. When taxpayers undertake risky investments, the government taxes fully any gain that they realize if the investment has a positive return. But the government allows only partial tax deduction if the venture goes sour and results in a loss.

There is one other large inequity of the capital gains tax. It represents a form of double taxation on capital formation. This is how economists Victor Canto and Harvey Hirschorn explain the situation:

A government can choose to tax either the value of an asset or its yield, but it should not tax both. Capital gains are literally the appreciation in the value of an existing asset. Any appreciation reflects merely an increase in the after-tax rate of return on the asset. The taxes implicit in the asset's after-tax earnings are already fully reflected in the asset's price or change in price. Any additional tax is strictly double taxation.

Take, for example, the capital gains tax paid on a pharmaceutical stock. The value of that stock is based on the discounted present value of all of the future proceeds of the company. If the company is expected to earn Rs.100,000 a year for the next 20 years, the sales price of the stock will reflect those returns. The "gain" that the seller realizes from the sale of the stock will reflect those future returns and thus the seller will pay capital gains tax on the future stream of income. But the company's future Rs.100,000 annual returns will also be taxed when they are earned. So the Rs.100,000 in profits is taxed twice--when the owners sell their shares of stock and when the company actually earns the income. That is why many tax analysts argue that the most equitable rate of tax on capital gains is zero.