The Hon'ble Finance Minister deserves recognition for streamlining the taxation rates concerning capital gains. This rationalization comprises three main components, thoroughly explained under the heading "Rationalisation and Simplification of Taxation of Capital Gains" in the Memorandum of the Finance Bill 2024. These components are analyzed in the subsequent paragraphs.
The Three Components of Rationalization:
Standardization of Holding Periods: The first component proposes standardizing the holding periods to two categories: 12 months and 24 months. For listed securities, the holding period is set at 12 months, while for all other assets, it will be 24 months. This amendment in clause (42A) of section 2 of the Act redefines a short-term capital asset. Consequently, units of listed business trusts will now have a 12-month holding period, similar to listed equity shares, instead of the previous 36 months. The holding period for bonds, debentures, and gold will be reduced from 36 months to 24 months. However, the holding period for unlisted shares and immovable property will remain at 24 months.
Impact Analysis: This simplification aims to create a uniform structure, reducing the complexities associated with different asset classes. By aligning the holding period for listed business trusts with equity shares, the amendment facilitates easier investment decisions and uniformity. However, the reduced holding period for bonds and debentures to 24 months may not significantly impact investor behavior, as the primary concern for investors in these instruments is typically the interest yield rather than capital appreciation.
Illustration: Consider an investor holding listed bonds. Previously, to avail long-term capital gains tax benefits, the holding period was 36 months. Now, with the holding period reduced to 24 months, the investor can sell the bonds after two years and still benefit from long-term capital gains tax rates, making bonds a more attractive investment.
Tax Rate Adjustments: Section 111A of the Income-tax Act addresses short-term capital gains tax in specific cases. The Government has proposed increasing the tax rate from 15% to 20% for units of equity-oriented mutual funds and business trusts, reasoning that the current rate benefits high-net-worth individuals. Other short-term capital gains will continue to be taxed at the existing rates. The tax rate for long-term capital gains on listed shares (where STT is paid) is proposed to increase from 10% to 12.5%, with the exemption limit raised from Rs. 1 lakh to Rs. 1.25 lakhs for STT-paid equity shares, units of equity-oriented funds, and business trusts. For bonds and debentures, the long-term capital gains tax rate will be reduced from 20% (without indexation) to 12.5% for listed bonds and debentures. The memorandum also states that unlisted debentures and bonds, being debt instruments, should be taxed at the applicable rate, whether short-term or long-term, under section 50AA of the Act. This amendment will take effect from July 23, 2024.
Impact Analysis: The proposed tax rate adjustments aim to generate additional revenue by targeting high-net-worth individuals benefiting from lower tax rates on short-term gains. Increasing the short-term capital gains tax rate to 20% for units of equity-oriented mutual funds and business trusts is expected to have a moderate impact on market dynamics, potentially reducing short-term trading activities. The modest increase in long-term capital gains tax to 12.5% for listed shares may slightly affect long-term investors, though the raised exemption limit provides some relief. The significant reduction in the tax rate for long-term gains on listed bonds and debentures to 12.5% is likely to incentivize investments in these instruments, promoting liquidity in the debt market.
Illustration: An investor holding listed equity shares with a gain of Rs. 2 lakhs currently pays 10% tax on gains above Rs. 1 lakh. Post-amendment, the investor will pay 12.5% tax on gains above Rs. 1.25 lakhs. This increases the tax liability slightly but raises the exemption limit, balancing the impact.
Removal of Indexation Benefit: The third component involves amending the second proviso to section 48. Previously, this proviso allowed for the indexation of the cost of acquisition and improvement for long-term capital gains, except for gains arising to non-residents from transferring shares or debentures of an Indian company. The Finance Bill 2024 proposes removing this indexation benefit in light of the rationalized tax rate of 12.5%.
Impact Analysis: The removal of the indexation benefit for long-term capital gains marks a significant shift in taxation policy. Indexation allows for adjusting the cost of acquisition according to inflation, thereby reducing the taxable gain. Eliminating this benefit, even with a reduced tax rate of 12.5%, may increase the effective tax burden on long-term investors, particularly in a high-inflation environment. This change could discourage long-term investments, as investors might seek alternative avenues with better post-tax returns.
Illustration: Previously, an investor who bought property for Rs. 10 lakhs in 2000 and sold it for Rs. 50 lakhs in 2024 could index the cost to Rs. 30 lakhs, thus paying tax on Rs. 20 lakhs. Post-amendment, the investor pays tax on Rs. 40 lakhs, increasing the tax liability significantly, despite the lower tax rate.
Concluding Remarks: The rationalization of capital gains taxation provisions is a well-thought-out move that aims to simplify the tax structure and create parity between different types of investors. However, the overall impact on investor behavior and market dynamics needs careful consideration. The simplification of holding periods and tax rate adjustments provide clarity and uniformity, but the removal of indexation benefits could offset these gains by increasing the tax burden on long-term investors.
Corresponding amendments to sections 115AD, 115AB, 115AC, 115ACA, and 115E of the Act have been proposed to align the rates of taxation for long-term and short-term capital gains as per sections 112A, 112, and 111A of the Act. While the intent behind these changes is commendable, the actual outcome will depend on how investors adapt to the new tax landscape.
