Capital Gains and Indexation: Analysis and the Way Forward

Why Tax Capital Gains?

When a capital asset is sold it fetches a price higher, lower or same as the price at which it was acquired. The first case is called capital gain, while the second is capital loss and the third situation is neutral. Tax laws in many jurisdictions classify the gains/loss as short term or long term. There is no unanimity among countries regarding taxation of capital gains, particularly on immovable properties. The view depends upon the principles of taxation being followed in a country.

One can argue that investment in immovable property is neither like interest income nor like dividends, which are compensations to investors by entities which use the fund to earn income. On the other hand, the price of immovable property may increase simply by holding on the property without earning income. The price rise of a property can be either due to inflation and/or mismatch in demand-supply situation. The reasons for taxing the gain are based on political or social aspects of public finance. The taxation of transactions in immovable property benefits all authorities — Central Government through income tax, State governments through Stamp Duty and local authorities and organisations through various levies and charges. All these organisations need money for meeting various expenses.

History of Taxation of Capital Gains in India

The Income Tax Act, 1922 neither defined the term "capital gains" nor its taxation was clearly stated. Capital gains were charged specifically, for the first time by the Income-tax and Excess Profits Tax (Amendment) Act, 1947, which inserted section 12B in the 1922 Act which was amended by the Finance (No.3) Act, 1956, w.e.f. 01^st April 1957.

This consisted of three sub-sections:

• Sub-section (1): The substantive section which levied a tax in respect of profits or gains arising from the sale, exchange or transfer of a capital asset effected during specified period.
• Sub-section (2): Stated how the amount of capital gain shall be computed, allowing certain deductions from the full value of the consideration for which the sale, exchange or transfer of capital assets was made.
• Sub-section (3): Referred to a capital asset which became the property of the assessee by succession, inheritance or devolution or under any specified circumstances, stating what deductions the assessee was entitled to.

The levy was virtually abolished by the Indian Finance Act, 1949, which confined the operation of the section to capital gains arising before April 1, 1948; but it was revived with effect from April 1, 1957, by the Finance (No. 3) Act, 1956 on the recommendation of Prof. Nicholas Kaldor. Since then, taxation of Capital Gains as a separate head of income has become a permanent feature of the Indian tax law.

Taxation of Capital Gains Under Income-tax Act, 1961

The Income-tax Act, 1961, when introduced, made significant departure from the approach of taxation of capital gains as existing under the earlier law. Since then, changes have been made consistently. The Finance Act, 1987 introduced definition of the terms "long-term capital asset", "short-term capital assets", "long-term capital gain" and "short-term capital gain".

The Finance Act, 1992 introduced important changes in law as well as procedure. Prior to the amendments an asset was considered to be long-term if it was held for more than 36 months except for shares of companies, where the holding period was 12 months. Further, a basic deduction of Rs. 15,000, along with a fixed percentage of the remaining capital gains, was permitted under section 48(2). The specific percentage varied depending on the nature of the asset and the status of the assessee, but it was not linked to the duration of the holding period. This deduction was designed to provide a straightforward relief from inflation, prevent the bunching of profits, and exempt relatively small capital gains from being taxed.

To further mitigate the effects of inflation, any increase in the value of assets prior to April 1, 1974, was excluded from taxation. This approach provided some inflationary relief but lacked a direct connection to the actual period the asset was held.

The introduction of indexation by the Finance Act, 1992 was aimed at achieving this fairer approach. Under indexation, both the cost of acquiring the asset and the cost of any improvements made to it are adjusted for inflation. This adjustment results in an indexed cost of acquisition and an indexed cost of improvement, which are then deducted from the sale price to calculate the long-term capital gains.

The cut-off date for determining the value of assets for indexation purposes was April 1, 1981. For any asset acquired before this date, its value as of April 1, 1981, was to be taken as the base for indexation. Only improvements made to the asset after this date were to be considered for indexation purposes. This system was incorporated to ensure that the calculation of long-term capital gains takes into account the impact of inflation over the period the asset was held, leading to a more accurate and fair assessment of taxable gains.

Under the provisos to section 48(1)(a), non-resident Indians were originally protected from fluctuations in rupee value relative to the foreign currency used to purchase shares or debentures when calculating capital gains on their transfer. By the Finance Act, 1992 this protection was extended to all non-residents for long-term capital gains on such assets. Previously, non-resident Indians were also allowed additional deductions under section 48(2). However, since the protection from currency fluctuation already accounts for inflation, non-residents benefiting from this concession were not eligible for further relief through indexation. This scheme of taxation of long-term capital gains, broadly, continues till date.

Amendments Made by the Finance (No. 2) Act, 2024

The Memorandum to the Finance (No. 2) Bill, 2024 explains that the changes proposed in the Bill aimed to rationalise and simplify the taxation of capital gains, focusing on three key aspects:

1. Holding Period Simplification: There will now be only two holding periods: 12 months and 24 months. For all listed securities, the holding period will be 12 months, while for all other assets, it will be 24 months. This change is reflected in the amendment to clause (42A) of section 2 of the Act. Notably, units of listed business trusts will be treated similarly to listed equity shares, reducing their holding period requirement from 36 months to 12 months. The holding period for bonds, debentures, and gold will decrease from 36 months to 24 months, while the holding period for unlisted shares and immovable property will remain at 24 months.
2. Adjustment of Tax Rates:
   • Short-Term Capital Gains (STCG): The tax rate on short-term capital gains for Securities Transaction Tax (STT) paid equity shares, units of equity-oriented mutual funds, and units of business trusts under section 111A of the Act has been increased from 15% to 20%. This change aims to address concerns that the current rate disproportionately benefits high-net-worth individuals. Other short-term capital gains will continue to be taxed at their applicable rates.
   • Long-Term Capital Gains (LTCG): The rate for long-term capital gains has been standardized at 12.5% across all asset categories. Previously, the rate was 10% for STT-paid listed equity shares, units of equity-oriented funds, and business trusts under section 112A, and 20% with indexation for other assets under section 112. The exemption for long-term capital gains on STT-paid equity shares, units of equity-oriented funds, and business trusts has been increased from Rs. 1 lakh to Rs. 1.25 lakh (aggregate). Additionally, for listed bonds and debentures, the LTCG tax rate has been reduced from 20% (without indexation) to 12.5%. However, while computing tax liability under section 112, on capital gains arising on transfer of a long term capital asset, being land or building or both, acquired before 23^rd July 2024, the excess income-tax computed at 12.5% over the income tax computed in accordance with the provisions of the Act, as they stood immediately prior to this amendment shall be ignored.

1. Indexation Removal: The indexation benefits currently available under the second proviso to section 48 for calculating long-term capital gains on property, gold, and other unlisted assets is being removed, on the basis that the rate of taxation has been reduced from 20% to 12.5%. This excluded assets acquired before 23^rd July 2024, thus providing grand-fathering benefit.
2. Taxation Parity Between Residents and Non-Residents: To ensure parity between resident and non-resident taxpayers, amendments are made in sections 115AD, 115AB, 115AC, 115ACA, and 115E to align the tax rates for long-term and short-term capital gains with the rates under sections 112A, 112, and 111A.
3. Withholding Tax Provisions: Consequential amendments are also made in sections 196B and 196C to align the withholding tax provisions.

International Approach to Taxation of Capital Gains

Most of the countries have separate provisions for taxing capital gains. In the United Kingdom for the year 2023-24 tax year, individuals could claim a £3,000 capital gains tax allowance. There were two capital gains tax rates:

• 10% (18% for residential property) if the overall annual income was below £50,270
• 20% (24% for residential property) if the overall annual income was above the £50,270 threshold

In the US, capital gains can be subject to either short-term tax rates or long-term tax rates. Short-term capital gains are taxed according to ordinary income tax brackets, which range from 10% to 37%. Long-term capital gains are taxed at 0%, 15%, or 20%. The short-term capital assets are those which are held for one year or less.

In Australia, companies and individuals pay different rates of capital gains tax. Companies are not entitled to any capital gains tax discount and pay 30% tax on any net capital gains. For individuals, the tax rate is the same as the income tax rate for that year. For Self-Managed Super Funds, the tax rate is 15% and the discount is 33.3% (rather than 50% for individuals).

Rationale for Retaining Indexation on Capital Gains in India

The price of an asset changes, normally, due to either one or a combination of two factors: inflation, and market demand and supply. So far as the second reason is concerned, it depends on the risk-bearing appetite and holding capacity of a person. On the other hand, inflation-driven factors are not within control of a person.

It may be mentioned that the average rate of inflation in UK, US, and Australia during 1990-2022 has been quite low, except during exceptional years. Apparently, due to this factor, these countries did not consider indexing cost of capital assets for computing long-term capital gains. Hence, there was no reason for making adjustment to the price due to inflation. On the other hand, the rate of inflation has been high in India, which has been at the root of the concept of indexation of costs for determining capital gains.

Indexation adjusts the purchase price of assets like stocks, bonds, or real estate to account for inflation, using the Consumer Price Index (CPI) as a reference. This adjustment helps reflect the true increase in an asset's value by factoring in the decrease in purchasing power over time. By applying indexation, investors can accurately calculate capital gains, ensuring that taxes are imposed only on the real gains exceeding due to inflation. This leads to a fairer taxation process, as it prevents inflation from inflating the taxable amount.

In view of the fundamental reason for indexation mentioned above, removing it on the basis of reduction of tax rate does not address the basic increase in the price of an asset.

Proposed Original Amendment and Subsequent Amendment on Indexation

As mentioned supra, the Finance (No. 2) Bill, 2024 originally proposed to do away with indexation for computing capital gains. After presentation of the Bill, a spate of representations was made by taxpayers, and various business and professional organisations. Considering these, on 6^th August 2024, the Finance Minister moved an amendment to section 112.

As per the amendment, individuals or Hindu Undivided Families (HUF) having purchased long-term capital assets, being land or building or both before 23^rd July 2024 can compute their taxes under section 112 under two options and pay tax using either option, whichever is more advantageous:

• Option 1: Index the cost of acquisition and costs of improvement, then compute capital gain and apply a 20% tax rate.
• Option 2: Apply a tax rate of 12.5% without applying indexation to the costs of acquisition and improvement.

On the other hand, for assets acquired after 23^rd July 2024, a tax rate of 12.5% on the capital gains would be applied without indexing costs.

A Practical Approach to the Issue

No doubt, the government has sought to appease taxpayers by giving some benefit. However, the basic conceptual issue remains. Economically as well as on equity basis, it would have been better if the old regime was brought back. An option might have been given to taxpayers to adopt indexation coupled with a 20% rate of tax or accept taxation at the rate of 12.5% without indexation, independent of the date of acquiring the long-term asset.

This approach is not new to the tax department; for example, an option has been given to taxpayers to choose between the Old or New regime for taxation, and the option is available to taxpayers to go to the Commissioner of Income Tax (Appeals) or Dispute Resolution Panel. Having a cut-off date may give rise to manipulation of dates and thereby lead to litigation.