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The Rediff Business Special/A N Shanbhag

Between the lines: Budget and capital gains

The various Budget provisions dealing with capital gains are shrouded in confusion.

Non-Resident Indians were charged tax at 20 per cent on long term gains along with the protection of cost inflation index, the same as residents.

However, for long term gains arising out of transfer of listed securities as defined in Section 2(h) of Securities Contract (Regulation) Act, 1956, the NRIs are charged at the concessional rate of ten per cent along with the protection against exchange risk.

There were protests from the disgruntled residents. To bring the residents on par with the NRIs, the tax on long term gains from shares and listed securities will now have a ceiling of ten per cent without indexation.

In other words, a resident assessee will be charged tax on capital gains, in respect of shares and securities, at 20 per cent with indexation or at ten per cent without indexation, whichever is lower. On all other assets, the tax continues to be at 20 per cent. Naturally, the question of protecting residents against the exchange risk does not arise.

I find that units of mutual funds do not fall under the definition of securities, even if these are listed.

On the other hand, bonds and debentures of public companies and financial institutions such as the ICICI and IDBI pass the test of being securities.

It is obvious that in some cases it would be beneficial to pay 20 per cent tax with indexation and in some others, 10 per cent without indexation. What is the break-even point?

Slightly complicated but the mathematical formula is as follows: A = ratio of sale and cost, B = compute the ratio of cost inflation indices in the year of sale and the year of purchase. Multiply by 2. Subtract 1. If A and B are equal, ten per cent without indexation is equal to 20 per cent with indexation. If A is greater than B, the ten per cent rate is beneficial, otherwise 20 per cent.

Bonus shares and bonds/debentures of public companies, including those issued by the ICICI and IDBI would gain the most from this amendment. Reasons vary.

The cost of acquisition of bonus shares is required to be taken as nil. Consequently, benefit of indexation is rendered redundant (anything multiplied by zero is zero itself). The indexation benefit is expressly not available to long term gains arising from transfer of bonds and debentures, other than indexed bonds issued by the government.

In any case, sale or transfer of shares and bonds attract capital gains. Henceforth, the ten per cent rate will be applicable to them.

The Budget lays down categorically that profits and gains arising from an insurance claimed on account of destruction or damage of capital asset due to fire, flood, earthquake, civil disturbance, wars, etc, shall be deemed to be capital gains. It is not yet clear whether indexation is applicable.

This is to negate the principle laid down by the case law, Vania Silk Mills Private Limited vs CIT (1991) 59 Taxman 3 (SC), where compensation received under an insurance policy towards destruction of property (in this case by fire), was not considered transfer.

Transfer presumes the existence of both the asset and the transferee. When the property is destroyed, both these criteria are not satisfied.

What about buyback? Another case law, Anarkali Sarabhai v CIT (1997) 90 Taxman 509 (SC), has laid down the principle that redemption of shares by the company which issued the shares (in this case preference shares) is tantamount to sale of shares by the shareholders to the company.

The Budget has reiterated this stand to remove any confusion. Now, where any company purchases its own shares, then, subject to the provisions of Section 48, the difference between the consideration received by the shareholder and the cost of acquisition will be deemed to be capital gains.

Further, this will not be treated as dividend since the definition of dividend does not include payments made by company on purchase of its own shares.

Employee stock options or ESOPs and sweat equity (specified securities) allotted or transferred by the employer free of cost or at concessional rates is a perquisite taxable in the year in which such option is exercised. This value will be the difference between the fair market value and amount paid for acquiring the shares.

However, the cost of acquisition shall be the fair market value on the date of exercise of the option for the purpose of computing capital gains when the shares are eventually sold by the employee.

While introducing the radical changes in the structure of tax on long-term gains, the tax officials appear to have forgotten to make a corresponding change in Section 45(6) dealing with units issued under Section 80 CCB. This continues to state: "The difference between the repurchase price of the units and the capital value of such units shall be deemed to be the capital gains arising to the assessee."

I think that this is an error of omission. It cannot be the intention of the legislation to deny the privilege of indexation only to this particular financial asset.

On the other hand, it could have been an intentional move in view of subsequent CBDT circular F. No. 225/4 B/-ITA II. No. II dated March 12, 1996 dealing with bonds. It states: "The difference between the issue price and the redemption price of Deep Discount Bonds will be treated as interest income assessable under the Income-Tax Act. On transfer of bonds before maturity, the difference between the sale consideration and issue price will be treated as capital gains/loss if the assessee purchased them by way of investment. However, in the case of assessee who deals in purchase and sale of bonds, securities, etc, the profit or loss shall be treated as trading profit or loss."

Confusion reigned. Later, FA97 inserted a third proviso in Section 48 denying indexation to the bonds.

This raised another doubt. In view of specific provision in respect of bonds, can I assume that indexation is applicable to the units of mutual funds under Section 80 CCB, where such a specific provision does not exist?

I feel that the Budget has confounded this confusion.

In the case of buybacks, the newly inserted Section 46A does state that the difference between the consideration received by shareholder and the cost of acquisition will be deemed to be capital gains but qualifies it further that this is subject to the provisions of Section 48. Since it is the Section 48 that deals with indexation, should it be inferred that the benefit is also available in the case of buyback?

There is another difficulty. The circular of the Central Board of Direct Taxes dealing with bonds requires the difference between redemption value and the face value to be construed as interest if the bonds are redeemed by the company that has issued the bonds. Will the new provisions for buyback apply to bonds also?

In that case, the difference between the redemption proceeds and cost of acquisition will be construed as capital gains, and that too subject to the provisions of Section 48?

I feel a further clarification is necessary.

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