Fiction of Law & Capital Gains Taxation

Those who wish to explore the concept of Fiction of Law will find interesting examples of the same in the labyrinthine maze called Income Tax Act 1961. A legal fiction in simple words is defining something to be true for the sake of convenience. Of course, “convenience” is something that the government of the day decides through deeming provisions in the statutes passed by the legislature.  When it comes to construction of tax statutes it is important to bear in mind that the concept of “natural justice” rarely prevails, as courts have consistently held that “tax and equity are strangers” which implies that fiction of law is taken to its logical conclusion even when such conclusions appear to be illogical!  

Capital gains is defined differently for different kind of assets and their taxation varies depending on the type of asset and its holding period. Fortunately, Budget 2024-25 has simplified the definitions and taxation provisions to some extent. Following table summarizes the changes.

The revised LTCG tax now provides a more favourable environment for overseas investments, at a time when Indian markets are overvalued. Investors, HNIs in particular, through the GIFT city in Gujarat, could directly invest up to $250000 in a financial year under the RBI’s Liberalized Remittance scheme in overseas equities/funds. International equities/funds now enjoy parity with Indian equities, albeit with a 24 month holding period for LTCG classification, down from 36 months earlier. Another opportunity that opens up for HNIs is in the space of unlisted shares, since the tax harmonization proposed in the budget aligns the taxation of gains from unlisted shares with that of listed shares except for the waiting period, to be eligible for LTCG taxation.

But in a country with aspirations of being Vikshith Bharath before long, the need to accelerate investments backed by risk capital cannot be overemphasized. But the last few budgets of FM Nirmala Sitharaman seem to be increasingly diluting the significance of this source of high powered savings garnered though equity capital when it comes to tax treatment. While increasing short term capital gains tax is understandable, increasing the same on long term capital gains on equities is something that cannot be appreciated in an economy that is hungry for high powered risk capital. A better option to consider would have been to increase the holding period to, say, 2 years and abolish tax on gains made thereafter. Given the speculative fervor fuelling the markets at present, this change might turn out to be revenue neutral, if not positive.

It is also encouraging to see the Finance Minister heed the concerns raised by a large number of investors on removal of indexation benefit on investments in house property/land which would affect investments made prior to the budget. She moved an amendment to the proposed LTCG taxation in respect of realty sector. In the case of transfer of a long term capital asset being land or building or both, by an individual or HUF which is acquired before July 23, 2024, the taxpayer can compute tax under the new tax rate at 12.5% without indexation and the old scheme at 20% with indexation and pay tax which is lower of the two. It has to be appreciated that the Finance Minister has honoured the promise to ensure that changes in taxation rules are not brought about with retrospective effect.

Treatment of capital gains in the case of buyback of shares, however, leaves some questions unanswered. Earlier buyback proceeds were tax free in the hands of the shareholder as the tax was paid by the company which meant that the tax burden was borne by the continuing shareholders and not the seller. This provision is now replaced under which the entire sale proceeds of shares sold in the buyback offer is treated as dividend in the hands of the shareholder and taxed at slab rate. The cost of acquisition of the shares sold is treated as capital loss which can be set off against future capital gains. This is likely to result in companies almost entirely resorting to buyback through open market purchases instead of through tender offer. Shareholders who sell shares during the period when the company is buying back its shares in the open market will pay only 12.5% LTCG tax and not on the sale proceeds at the applicable slab rate as proposed under the new provision when shares are sold under the buyback offer. Well, it is possible to resort to a fiction of law through a deeming provision which could state that proceeds of any sale of shares of the company in the period during which the company is buying back its shares from the open market will be treated as dividends! It seems that such treatment may not only be regarded as discriminatory but turn out to be disruptive and hence may not be feasible. But bureaucrats are known to have resorted such to quixotic proposals in the past! Another complication can arise when a company takeover occurs, where an offer for usually 26% of the total shareholding has to be made to the public shareholders. How will the sale proceeds be taxed in such cases? This question remains to be resolved.

It is worthwhile to note that the existing provisions that enable an investor investing in residential property and specific bonds, to minimize capital gains tax outgo are retained.

Under Section 54, the seller of residential house property is required to invest the sale proceeds in another residential house property in India to be constructed within three years or to be purchased within two years from the date of sale or to have been purchased within one year before the date of the sale. In case your capital gain does not exceed Rs 2 crores, you can invest in not one but two house properties, although this option is available only once in a lifetime. The quantum of exemption under this section shall be lower of:                                      

 a) Capital Gains,                                                                                                                                         

  b) Cost of new asset (limited to Rs 10 crores)                                                                                     

This exemption comes with a three year lock-in period on the new asset

Under Section 54EC, taxpayer gets exemption if the capital gains from sale of land, building or both are invested in specified bonds issued by REC, PFC etc. Maximum investment in these bonds is capped at Rs 50 lacs in a financial year. The quantum of exemption under this section shall be the lower of capital gains or cost of the bonds purchased. These bonds at present carry a coupon rate of 5.25% and have a lock-in period of 5 years. It has to be noted that even the act of using these bonds as collateral for loans will be considered a breach of lock-in period.  

Section 54F deals with exemption from long term capital gains on sale of all kinds of capital assets (including shares, mutual funds) except residential house properties. To claim the exemption under the section, taxpayer has to invest the sale proceeds in one residential house property in India to be constructed within three years or to be purchased within two years from the date of sale or to have been purchased within one year before the date of sale. The quantum of exemption is calculated as A*(B/C), where A is the capital gains on sale of the original asset, B is the cost of the new asset and C the proceeds from the sale of the original asset. B, that is cost of the new asset, is however limited to 10 crores. Further, the following conditions have to be satisfied to be eligible for the above exemption.

1. The assessee should not have owned more than one residential house apart from the new asset, on the date of sale of the original asset.
2. The assessee should not have purchased another house property, apart from the new asset within two years from the date of sale of the original asset and should not have constructed another house apart from the new asset, within three years from the date of sale of the original asset.
3. A lock-in period of three years applies to new asset.

Claiming exemption under one of the above sections does not preclude an eligible taxpayer from claiming exemption under another section as per expert opinion.