Made capital gain/loss? Know the set-off math

Many retail investors are looking to take advantage of the soaring indices by selling their stock and mutual fund holdings. They are doing this to not only book profits but also to try and adjust such profits against any loss-making investment, thereby minimising the tax on capital gain.

In fact, last week, Vikas, a client who has now become a good friend, emailed me some questions on this topic. Since his queries encompass a number of issues relating to capital gains and losses and the tax treatment thereof, I thought of sharing them here.

Admittedly, the topic is a bit technical, but I assure you, if you stay with it, it would be of immense benefit for your tax planning.

Here’s what Vikas asked:

1. I understand long-term capital gains (LTCG) on shares and equity mutual funds (MFs) are exempt from tax provided securities transaction tax (STT) has been paid on the transaction. LTCG is payable at the rate of 10% or 20% with cost indexation, whichever is lower. Also, on assets other than shares and equity MFs, LTCG is payable either at 10% or 20% as the case may be. Am I right on this?

2. Say during the current year one incurs some long term capital loss (LTCL) and LTCG on various sale transactions of equity shares. Can the LTCL be set off against LTCG? If not, then what can be done about such LTCL?

3. Also advise if setting-off is permitted against any other income —- say short term capital gain (STCG) or salary or business income. If for any reason, the loss cannot be set off fully, can it be carried forward to next year for a possible set-off?

4. Lastly, for most of my mutual fund investments, I had chosen the dividend option. Now, if I were to switch to the growth option, will there be any tax incidence? There is no tax for such switching in unit linked insurance plans of insurance companies. Is similar tax exemption available to MF switches?

My answer:

1. Your understanding contained in the first point above is perfect. Any LTCG arising out of sale effected on or after October 1, 2004 of equity shares is tax-exempt provided such transaction has taken place on a recognised stock exchange in India and the investor has borne the STT. The LTCG earned from sale of units of equity oriented MF schemes is also exempt from tax.

Therefore, to summarise —

LTCG is exempt and consequently not available for set-off of LTCL or STCL or the carried forward losses of yesteryears;

As a corollary, LTCL is also ‘exempt’ and cannot be set off against LTCG;

STCG earned shall be charged to tax @15% flat;

LTCL was never allowed to be set off against STCG either before or after October 1, 2004;

STCL can be set off against any STCG, or taxable LTCG (say on non-equity units or property, etc).

The point regarding set-off requires further discussion. The Income Tax Act draws a boundary around capital gain incomes and losses. In other words, capital losses can only be set off against capital gains —- other incomes like salary or business income cannot be used for set-off. Now, LTCL can only be set off against taxable LTCG. However, STCL can be set off against both STCG as well as taxable LTCG. This rule existed much before the exemption to LTCG was brought in. The reason is that setting off long-term loss against short-term gains created a sort of tax arbitrage since STCG is taxable at a higher rate (30% in most cases) than LTCG. Therefore, it has been provided by the law that LTCL shall only be set off against taxable LTCG while STCL may be set off against both taxable LTCG as well as STCG.

STT is not required to be paid on the following types of transactions, even if these take place on or after October 1, 2004

Sale or purchase of any asset other than equities and units of equity-based schemes of MF;

Sale or purchase of equity shares which have not taken place on a recognised stock exchange in India;

Redemptions or buy-backs of its shares, preferential or otherwise, by the companies.

On such assets, capital gains and losses shall continue to be taxed as per the old provisions. This means —

LTCG on non-equity based schemes will be charged to tax @10% without indexation or @20% with indexation, whichever is lower.

STCG is considered as normal income of the assessee, added to the income and taxed at the slab rate applicable to him. Consequently, the rate depends upon his other income.

2. If LTCG is tax-free, LTCL is also tax-free. In other words, any LTCL incurred from October 1, 2004 arising out of sale of equity shares or units of equity-oriented MFs cannot be set off against any LTCG, even the one arising out of say, housing property. This is the inherent provision of Sec. 10(38) itself.

3. In this regard, note that set-off if possible has to be applied, i.e. the taxpayer does not have the option of paying tax on the gains and carry forward the outstanding losses.

However, it is possible to save tax on long-term capital gains by using Sec. 54EC, 54F, 54 etc, and carry forward the losses.
Take the case of an individual who has earned taxable LTCG and has invested the gains immediately thereafter in NHAI bonds to come down to nil tax on capital gains. Later, during the same FY, he has incurred a long-term capital loss.

Will the loss have to be set off against the gains in spite of the taxpayer having invested in the bonds u/s 54EC? Again, will the loss not be allowed to be carried forward?

The answers to these questions lie in the fact that Sec. 54/54EC/54F, etc are exemptions and not deductions. In other words, if an income is eligible for exemption, it is not to be included in the computation of income. On the other hand, deductions (Secs. 80C, 80G, 80D, 80U etc.) are to be claimed after having aggregated the incomes from different sources.
After having claimed the exemption u/s 54/54EC/54F, etc, an income ceases to be taxable and will not be included in the computation of total income. As such, the full amount of capital loss can be carried forward.

For greater clarity, even if the assessee earns LTCG later in the same FY, he can invest in bonds within 6 months, claim exemption u/s 54EC and carry forward the loss.

4. Lastly, a switch from dividend to growth or growth to dividend option (unlike Ulips) does attract capital gains tax liability. Therefore, if the switch that you are contemplating is within the options in an equity MF, take care to see that you have invested over one year ago. In that case, LTCG would be exempted; else the same would be taxable. However, a switch from dividend to dividend reinvestment option will not invite any tax liability. Since due to current tax laws, there is no difference between dividend reinvestment and growth, it is suggested that if the switch is being made before a holding period of one year, it should be done in the dividend reinvestment option. This would give similar benefit as the growth option but without the attendant tax liability.

The writer is director, Wonderland Consultants, a tax and financial planning firm and can be reached at sandeep.shanbhag@gmail.com.