BUDGET 2018 : FINE PRINT DECODED


Ameet Patel(Partner, Manohar Chowdhry & Associates)
Whether in the short run or the long run, tax is the only constant!

For almost 14 years, investors have had a great time in India. Whether it is FIIs or local investors – everyone has enjoyed the 14 year “vanvaas” of tax on long term capital gains on transfer of listed shares and units of equity oriented mutual funds. Even the short term capital gains on these assets has brought a lot of joy to thousands of people across India. Whether it is the day traders or the more patient long term investors or the short to mid term middle class investors – everyone has loved the sections 10(38) and 111A of the Income-tax Act, 1961 (Act). Securities Transaction Tax (STT) which was brought onto the Statute by the Finance (No. 2) Act, 2004 simultaneously with the introduction of sections 10(38) and 111A has become a household word in India.

But, now, all that is about to change. And what a change it is! The amendments proposed in the Budget 2018 have brought the Dalal Street bulls onto their knees. On 2nd February, the BSE Sensex closed 840 points down and the NSE Nifty 50 closed 256 points down as compared to the previous closing figures. In both cases, the market cap or the shareholder wealth has eroded by lakhs of crores. This happened as a direct outcome of the amendments proposed to the taxation of long term capital gains on transfer of listed shares and units of equity oriented mutual funds.

In 2004, when the virtual “tax holiday” was announced, the Notes to Clauses explaining the amendments stated that “with a view to simplify the tax regime on securities transactions, it is proposed to levy a tax at the rate of 0.15 per cent on the value of all the transactions of purchase of securities that take place in a recognised stock exchange in India.” Thus, at that point of time, the focus was on “simplification” of tax law.

Section 10(38) provided an exemption to long term capital gains on transfer of shares listed on a recognised stock exchange (BSE & NSE) provided the transaction of sale was chargeable to STT. Section 111A stated that short term capital gains on such a transfer would be taxed @ 15%. As we all know, both the beneficial sections – 10(38) and 111A have been applicable to all types of investors irrespective of the tax residential status and the form of entity.

Now, in the Finance Bill, 2018, in the Budget Memorandum, it is mentioned that 

Under the existing regime, long term capital gains arising from transfer of long term capital assets, being equity shares of a company or an unit of equity oriented fund or an unit of business trusts , is exempt from income-tax under clause (38) of section 10 of the Act. However, transactions in such long term capital assets carried out on a recognized stock exchange are liable to securities transaction tax (STT). Consequently, this regime is inherently biased against manufacturing and has encouraged diversion of investment in financial assets. It has also led to significant erosion in the tax base resulting in revenue loss. The problem has been further compounded by abusive use of tax arbitrage opportunities created by these exemptions.

In order to minimize economic distortions and curb erosion of tax base, it is proposed to withdraw the exemption under clause (38) of section 10 and to introduce a new section 112A in the Act to provide that long term capital gains arising from transfer of a long term capital asset being an equity share in a company or a unit of an equity oriented fund or a unit of a business trust shall be taxed at 10 per cent. of such capital gains exceeding one lakh rupees.”

Thus, according to the government, the simplification brought in 2004 has resulted in inherent bias against manufacturing and there has been diversion of money into financial assets. There is also abuse of the provisions. The abuse referred to here probably alludes to the penny stock scams unearthed by the income-tax department. The government also seems to be of the view that these exemptions have resulted in erosion of tax base. Per se – all the reasons given by the government for bringing about the change cannot be faulted. It is a fact that substantial taxes have been saved because of the exemptions. It is also a known fact that several penny stock scams have pointed to large scale abuse of the exemptions. Use of borrowed money for investing in stocks is also commonly done across the nation.

Considering the ramifications of the proposed amendments, it is imperative that we take a clos look at the changes.

The first point that needs to be noted by us is that the exemption presently available u/s. 10(38) will continue for all transfers made upto 31st March, 2018. There is no change in this for the rest of the current financial year.

Unfortunately, however, the amendment will apply to shares or units already acquired by anyone prior to the Budget (i.e. upto 31st January, 2018) as and when the same are transferred after 31st March, 2018. This is perceived to be unfair by many and is being criticised as being a retrospective amendment. 

But, as a consolation, special grandfathering provisions are put in place for such shares or units acquired on or before 31st January, 2018. For shares or units purchased on or after 1st February, 2018, there is no grandfathering available.

With effect from 1st April, 2018, the exemption u/s. section 10(38) will not be available. Simultaneously, a new section 112A is proposed to be introduced into the Act to provide the formula for computing the tax on the long term capital gains on the listed shares and units of equity oriented mutual funds transferred on or after 1st April, 2018. Thus, this new section is similar to section 112 which too provided for the computation of tax. An important point to be noted here is that sections 112 and the proposed 112A are not computation provisions for determining income. They are only for computing the tax. For the purpose of computing the total income, the normal provisions for each head of income will continue to be applicable. This is relevant because for computing long term capital gains (for the purpose of computing total income), the benefit of indexation will continue to be available. 

If this view is taken, then in case of a loss, the same could be set off against other long term capital gains and tax would then be computed only on the balance long term capital gains as per section 112A. In any case, this will obviously help in reducing the taxable capital gains that goes into the Gross Total Income and thereafter the Total Income since indexed gain would generally be lower than the unindexed gain. The lower the total income, the lower will be the chance of attracting sur charge. However, it may be noted that on 4th February, the CBDT has issued a set of 24 FAQs regarding the amendments proposed in the Finance Bill. As per these FAQs, it appears that the view of the CBDT is that even for the purpose of computing the income, indexation is not available. In my view, this is incorrect since section 48 has not been amended.

As per section 112A, for computing the tax on long term capital gains, the capital gains will have to be recomputed (as compared to the gains that has gone into the Total Income). For this purpose, the cost to be taken into consideration would be as under:

      

For shares / units acquired upto 31st January, 2018

The cost will be higher of:

       a) Actual cost of acquisition and

      b) Lower of:

i)              Fair Market Value of the shares/units as on 31st January, 2018

ii)             Actual consideration received / receivable at the time of transfer

 

For shares / units acquired after 31st January, 2018

The cost will be actual cost of acquisition

 

For this purpose, “fair market value” means,—

(i) in a case where the capital asset is listed on any recognised stock exchange, the highest price of the capital asset quoted on such exchange on the 31st day of January, 2018: 

Provided that where there is no trading in such asset on such exchange on 31st day of January, 2018, the highest price of such asset on such exchange on a date immediately preceding the 31st day of January, 2018 when such asset was traded on such exchange shall be the fair market value;

(ii) in a case where the capital asset is a unit and is not listed on a recognised stock exchange, the net asset value of such asset as on the 31st day of January, 2018;”

This mechanism is explained below with a few examples:

 

 

Situation 1

Situation 2

Situation 3

 

 

 

 

 

A

Shares purchased in say, May 2016 for

Rs. 1,000

Rs. 1,000

Rs. 1,000

B

Fair Market Value as on 31st Jan 2018

Rs. 1,250

Rs. 1,500

Rs. 1,250

C

Actual Sale Price in August 2018

Rs. 1,500

Rs. 1,300

Rs. 900

D

Cost to be taken into consideration for calculating LTCG:

To compare actual cost & lower of B & C

Higher of 1,000 and 1,250

i.e. Rs. 1,250

Higher of 1,000 and 1,300

i.e. Rs. 1,300

Higher of 1,000 and 900

i.e. Rs. 1,000

E

LTCG / LTCL = C – D

Rs. 250

Rs. NIL

Loss of Rs. 100

 

Actual book profit/loss

Rs. 500

Rs. 300

Loss of Rs. 100

 

Thus, the gain that has already accrued upto 31st January, 2018 is grandfathered and will not be taxed in future

Rs. 250

(1,250 – 1,000)

Rs. 500 (1,500 – 1,000)

 

 

In the above table, tax on the LTCG will be computed on the figure in Row E in the first two situations.

It is also provided that while calculating the tax on these types of long term capital gains, indexation of cost will not be permitted. So, whatever is the actual cost, that figure has to be taken as it is (as explained above). Secondly, the deductions under Chapter VI-A of the Act will also not be available against these long term capital gains. For Non Residents, the option of computing the capital gains in foreign currency and then converting to INR is also not available for this type of long term capital gains. 

Once the gains are computed as per the examples given in the table above, the tax has to be computed. Section 112A states that for computing tax liability, the long term capital gains in excess of Rs. 100,000 will be taxed at 10%. The actual words used in the section are as under (emphasis supplied):

“(2) The tax payable by the assessee on the total income referred to in sub-section (1) shall be the aggregate of -

(i) the amount of income-tax calculated on such long-term capital gains exceeding one lakh rupees at the rate of ten per cent.; and

(ii) the amount of income-tax payable on the balance amount of the total income as if such balance amount were the total income of the assessee:”

One view is that what the Finance Minister intended in his budget speech was that in such cases, it will only be the excess over Rs. 100,000 that will be taxed and therefore, logically, for the first Rs. 100,000 of such long term capital gains, there will not be any tax. However, the actual section is worded in a manner that gives rise to a doubt about the taxation of the first Rs. 100,000 of such type of long term capital gains. The doubt is whether such Rs. 100,000 would not be taxable at all or whether it would be included in the normal income of the investor and taxed at the applicable slab rate.

Hopefully, we will see some amendment in the section which clarifies the intention.

An important condition for being covered u/s. 112A is that at the time of transfer of the shares / units, STT will have to be paid. An even more important condition is that STT should also have been paid at the time of acquisition of the shares. There is a provision for exempting certain categories of acquisitions from this requirement of STT having to be paid. Thus, for example, in case of bonus shares or rights shares or several other legitimate modes of acquisition, it is possible that STT was not chargeable at all at the time of acquiring the shares. Such situations would be notified later. A similar notification has already been issued in the context of section 10(38) last year. It is hoped that situations envisaged in section 49 will be included in this notification and so, for example, shares inherited or received as gift will not be adversely hit by the amendment.

There is no change proposed in the concessional tax treatment for short term capital gains on transfer of listed shares / units of equity oriented mutual funds. At present, these gains are taxable at 15%. This position remains untouched by the Budget 2018.

While the long term capital gains will be taxed in future, one of the existing ways of saving tax by investing in capital gains bonds specified in section 54EC will not be available in future. 

This is because in the Budget 2018, an amendment is also proposed to section 54EC whereby this section would apply only to long term capital gains on transfer of land or building or both. 

As far as FIIs and NRs are concerned, the same provisions of section 112A will apply to them. There is no distinction made between any category of taxpayers. Thus, even the grandfathering provisions will apply to FIIs and other NRs. Also, NRs will be entitled to DTAA benefits wherever available. For FIIs. Section 115AD has also been amended to provide for a 10% tax on the long term capital gains.

The amendments mentioned above are of far reaching consequences. One will have to wait and watch how the different classes of investors react in the months ahead. In particular, the strategy adopted by FIIs will be interesting to note. They form an important class of investors in our Indian stocks. While they no longer dominate our stock market, a large scale sell off by them could trigger further panic resulting in a further erosion of market capitalisation.

In the meantime, thousands of retail investors are trying to find an answer to the question as to whether they should sell of their existing long term holdings before 31st March, 2018 and then repurchase the shares after 31st March.

I would not hazard any advice in this matter. Not yet.

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