Selling your shares? See if FIFO changes anything

As the market started flirting with level 17000, more than anything else, Vishal felt an overwhelming sense of relief. It was as if he had been granted a reprieve and this time he was not going to make the same mistake.

It was almost a year-and-half back, around May 2008, that the market had touched 17000. At that time, against his better judgment, he had held on to his investments and refrained from booking partial profits. Like most of his friends, he was hopeful that the indices would climb further. However, the rest is history. More than 50% was shaved off in no time and he was left reeling under the shock.

However, fate had granted him another chance. Valuations had climbed again and it was time to book profits, at least partially. Buy low and sell high was a dictat he had followed successfully all his life, but for the recent slip. This also gave him an opportunity to clean up his portfolio, get rid of the dud shares and use such loss to set-off against his profits.

Earlier, investors could pick and choose the shares to sell, depending on whether such shares were long-term or short-term assets. The price paid for each purchase also played a part in the tax planning exercise. For example, bonus shares, where the cost is nil (resulting in a higher profit) could be chosen to sell along with those which would result in a substantial loss. This exercise essentially minimised the tax outgo.

However, Vishal’s CA had warned him that in the current dematerialised environment, such a tax planning exercise wasn’t as easy as earlier. This is on account of Sec. 45 (2A) of the Income Tax Act, which specifies that for shares sold in the demat form, the first-in-first-out (FIFO) system had to be applied.

In other words, for computing capital gain chargeable to tax, the cost of acquisition and period of holding of any security shall be determined on the basis of the FIFO method. This means the investor no longer has the discretion to select the specific lot of the scrip to be sold —- the one that is dematerialised first would be deemed to have been sold first.

Also, it may so happen that you may have bought shares in the demat form first and then submitted your old physical shares for dematerialisation. For example, in Vishal’s case, he had purchased some L&T shares way back in 2001 that he had forgotten to get dematerialised. He submitted the same for dematerialisation only in 2009, by which time he had already purchased shares in the company in the electronic form. How will the FIFO method work in this case?

Let’s say, Vishal sells 175 shares.

Under the FIFO system, the first entry, i.e. shares purchased on May 2, 2007, would be deemed to have been sold first. The next 75 shares would come out of the lot that had been dematerialised next, i.e. shares purchased in 2001.

Note that the date of dematerialisation has nothing to do with the tax treatment thereof. In the first lot, though the shares have been dematerialised on May 2, the date of acquisition still remains April 30, 2007. This concept becomes significant with the next entry.

Note that for the next entry, the shares have been dematerialised only on June 5, 2009. Does this make it a short-term asset? No. The date of acquisition of the shares is and remains March 2001, no matter when you submit the shares for dematerialisation.

The second important thing to note is that the first two entries represent shares purchased in 2007 and 2001, respectively, thereby making the same long-term assets. Remember, that long-term capital gains are tax-free and hence cannot be used to set-off any loss.

Ideally, Vishal would have liked to sell the shares purchased on July 23, 2009 (the third entry in his demat statement). This would have enabled him to book short-term capital gains, which could be in turn used to set-off against any loss booked simultaneously. However, such a tax planning exercise isn’t possible now.

However, there could be a way out. Note that the FIFO system is to be applied account-wise. In the depository system, the investor can have multiple accounts. He may have shares of the same scrip credited in more than one account.

For example, had Vishal owned L&T shares purchased less than one year ago in some other depository account, he could have chosen those to sell even though they had been bought after 2001 and 2007, respectively. In other words, FIFO is applied per account individually and not collectively to all demat accounts of the investor.

Last but not the least, FIFO is applicable only to shares and securities that are dematerialised. This means, this system is not applicable to mutual fund units. In the case of mutual fund units, the investor can definitely pick and choose the particular lot to sell. However, the tax treatment remains the same. In other words, in the absence of L&T shares, Vishal could very well have sold units of an equity oriented fund to get the same tax benefit.

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