The Income Tax Act is one such law in India that has utilised all means and all ways to tax your income. One such provision in this act is the Capital Gains tax, a tax which many experts argue over why does it even exist in place.
The best argument in support of their claim is the complexity involved in the taxation of capital gains. When laws are complex, it is clear how desperate the law is trying to achieve something which won’t be possible under normal circumstances.
In this article, we shall be decoding What is capital gains & What makes it such a big headache ?
This is a perfect guide for you to know all the basics of Capital Gains and Tax on Capital Gains in India.
So,go ahead and make yourself aware about these simple basics on Capital Gains !
What is Capital Gain and Capital Gains Tax?
Capital is an accounting term, meaning the amount invested into a monetary activity for the purpose of earning returns. It can be in cash or in kind. When you invest in business, it is called Capital for the business. Similarly, when you invest your savings into Fixed Deposits or Equities, the same amount is also your capital invested for the purpose of investments.
Extending the concept of Capital, when there is a gain in the value of capital invested, it is called Capital Gains.
In simple terms, when your wealth increases, the increment is called Capital Gains.
Example : If you purchase a land for 40 lakhs in 2016 and after two years the value of land is 60 lakhs, the increase of 20 lakhs is known as Capital Gains. It is important to note that Capital Gains can also be negative when the value of capital invested decreases instead of decreasing.
The tax on Capital Gains is popularly known as Capital Gains Tax. However, Capital Gains tax in India is not a different tax, but a part of income tax.
How did Capital Gains Tax come into existence?
We pay taxes on our income, the profits that we generate through our probations. Income is profits earned on Capital invested. It doesn’t affect the value of capital invested, apart from normal wear tear. It is important to note here that when profits are earned on capital invested, it is income; while the increase in the value of capital invested is called Capital Gains.
There is a very thin line of distinction between income and Capital Gains. So, when you invest in the business by purchasing machinery and land, the profits earned from production is your income, it doesn’t affect the value of machinery and land. On the other hand, if there is an increase in the value of land, then it is Capital Gains.
Another example is Equity investment. While the dividend is your income, the change in the value of the stock is your Capital Gains.
Now, what if I treat my profits as Capital Gains?
If I say, the money earned on assets are merely increment in the value of assets and not my profits or if the dividend earned on assets as an increment in the value of my equity investment and not profits? Since we pay taxes on income, by treating profit as capital gains, we could have easily escaped taxation. That is why we have Capital Gains tax. So whether you call it as profit on assets or capital gain, both will be taxed by Income Tax Authority.
For details on Income tax slabs you can refer : Income Tax slab rates for Financial year 2016-17
Why is Capital Gain Tax debatable as a Tax?
This is as simple as it could be – because it is Capital Gain and not income.
The income tax is a tax on your income and not the increment in value of your wealth.
If Capital Gains is different from income, why should we pay income tax on Capital Gains? This would have been debatable forever, however, tax authorities are cunning. They expanded the definition of income.
Section 2(24) clause (vi) says income includes capital gains which mean capital gains is also a type of income; and once it has been written in law, it becomes a rule, enforceable by the judiciary. So that’s the end of the debate over taxation of Capital Gains.
Many people still question how fair this kind of tax regime could be, however, the truth is if this kind of provision didn’t exist many people would have easily escaped taxation, resulting in Government’s loss.
What are the types of Capital Gains?
While in general, capital gains can be classified into various types depending on the types of asset.
Under The Income tax act, the capital gain is either Long-term capital gain or Short-term capital gain depending on the period for which we retain the asset. The period usually considered short term is 36 months (i.e. 3 years) while in some cases it is considered 12 months (i.e. 1 year).
So, if you hold the asset for less than 36 months or 12 months, as the case maybe, the gain on your asset, is short term capital gain and shall be taxed accordingly. Vice versa, if the period is more than 36 months or 12 months, it shall long-term capital gain and shall be taxed accordingly.
Why there is different rate of tax for Capital Gains?
Capital Gains are taxed at lower rates of 20%, 15% or 10% depending on their types. While normal income is taxed at 30%. This means Capital Gains are given preferential treatment under taxation laws and there are various reasons for the same.
- If Capital Gain is taxed at higher rates, it would discourage people from investing. If people don’t invest, the economy would suffer.
- Capital Gains should be calculated also considering the time value of money. What is worthy today, may not be equally worthy tomorrow, as the value of money decreases over time. Capital Gains are also due to inflation. Inflation increases the value of everything. It would be inappropriate to tax the increase in the value of an asset which is merely due to inflation. Hence, a lower rate solves this issue. This issue is further addressed by the Cost Inflation Index used while calculating Capital Gains.
- Taxing capital gains results in double taxation many times, especially equities. Let’s say, a company decides against distributing dividends, then the retained profits would be plunged back into a business which will result in growth & increase in profits. These profits are taxed as income. Therefore, a lower rate is a compensation towards the double taxation component.
Further, there are different rates of Capital Gain Taxes depending on Long term or short term and other taxes that are paid, such as Securities Transaction Tax (STT) in India.
If you are interested in knowing about taxation of mutual funds,you can go through our blog post Tax on mutual funds
Why is Capital Gains Tax such a headache?
How do we calculate income? Reduce the expenses from receipts and the net value is our profits i.e. income.
However, this is not the case with Capital Gains.
In Capital Gains, one has to calculate the increment in value of assets. To calculate the increment, we firstly need to calculate the value of the asset at the time of purchase. Then we need to calculate the value at the time of sale. Further, we also need to calculate the period for which the asset was held to decide whether short term or long term capital gain. This seems simple. However, the story doesn’t end there.
What constitutes an asset, itself is the first question. Then purchase value has to be adjusted according to the cost inflation index to adjust the time value of money. Sometimes, there are improvements in the assets which enhance it values at some cost which also needs to be considered.
Sometimes, there isn’t a purchase, but the asset is gifted, inherited or generated. In other cases, the asset isn’t sold but converted or reconstructed.
For detailed analysis on gifts received refer : All about Income tax on Gifts received in India !
There are various assets whose value is not available readily e.g. Goodwill, trademarks, etc. When companies merge, demerge or reconstruct, the capital gains calculation becomes scarier.
Further, sometimes there are slump sales where the value of assets is calculated in bulk, while they were purchased individually.
Hence.these all situations make the calculation of capital gains complex. With time, the taxation authorities filled in various loopholes and this also resulted in a more complex Capital Gains Tax law.
That’s why Capital Gains tax is a real headache even for tax professionals due to the varied situations that emerge in the taxation of Capital Gains.
Feel free to share your valuable feedback and any queries thereon in the comments section below !
If you are further thinking about investing your money wisely, you must have a look at one of our popular blog posts 7 Best Long term Investments in India that will surely guide you to invest your money in the right manner.
*Author Bio : This a guest post by Saurabh Toshniwal, who is a Chartered Accountant as well as Cost & Management Accountant and provides Business Consultancy Services. Besides, he is a Public Speaker, a Mentor for Students and a Technical as well as a Creative Writer.
Kindly note that,this is only a guest post and not a sponsored one.We have not received any monetary benefit for it.