The Sensex and Nifty extended losses on Monday on broadbased selling after Finance Minister Arun Jaitley reintroduced Long Term Capital Gains (LTCG) tax for equity transactions in Union Budget 2018-19 on February 1.
While the Sensex was trading 471 points lower, the Nifty was down 128 points in early trade.
In his Budget speech, FM Jaitley said, "I propose to tax such long term capital gains exceeding Rs 1 lakh at the rate of 10% without allowing the benefit of any indexation. However, all gains up to 31 January, 2018 will be grandfathered" Jaitley said.
In Budget 2004, the government withdrew LTCG tax on equity transactions and henceforth introduced Securities Transactions Tax (STT) which is a form of Tax at source so as to mitigate tax evasion.
We look at the details of the above excerpt from FM's speech.
What is Grandfathered?
This clause is a special provision under which an entity can be exempted from a new rule or regulation. This also means that the exemption shall be allowed to apply in certain cases in the future.
What are capital gains in case of equities?
Any equity-based security held for more than one year and resulting in profit/gain on sale will attract long-term capital gains tax with effect from April 2018, according to FM's Budget speech.
What does Indexation mean
FM Arun Jaitley proposed LTCG tax 'without allowing the benefit of any indexation'. Indexation for the purpose of capital gains means calculating the value of the asset taking into account the effect of inflation.
The need of indexation was felt with the general rise in prices and fall in the purchasing value of money in the long term. That's how indexation comes into play while calculating long-term capital gains.
Indexation benefit formula
Indexed Cost of Acquisition = (Actual cost of purchase) multiplied by (CII Of Year of Sale) divided by (CII of Year of Purchase).
Calculation of long-term capital gains for equity transactions
Prior to withdrawal of LTCG tax for equity transactions in October 2004, Benefit of indexation was available. However in the Union Budget 2018 , indexation was withdrawn and FM introduced a new formula for calculation of Cost of Acquisition of Equity for calculation of Long term capital gains. Same is elaborated with the help of an example.
An RIL stock was bought at Rs 300 in 2007 and the highest trading price of the RIL stock as on 31 January 2018 is Rs 1300. Now for the purpose of calculating LTCG, cost of acquisition of stock shall be higher of the following two
1. Actual cost of acquisition that is Rs 300
2. Highest trading price as on Jan 31, 2018 Rs 1300
Hence, cost of acquisition of the equity shall be Rs 1300. Now, if the RIL stock is sold on April 5, 2018 at Rs 1500, LTCG tax at the rate of 10% shall be calculated on difference amount of Rs 200 (Rs 1500-Rs 1300) which shall be Rs 20.
Impact of non Indexation in calculation of LTCG
The impact of non-indexation shall vary from one Equity trading to another, due to the change in the formula of Cost of acquisition. For example a Share of RIL was bought at Rs 390 on April 2013, is sold on April 2018 at the price of Rs 1000. Further the highest trading price of the share on 31st January 2018 was Rs. 962 then
A) With indexation: The cost of acquisition of share would have been Rs.514 (390*290/220) and hence the LTCG gain after indexation benefit would have been Rs 486 (1000-514). (CII for F.Y.2018-19 is yet to be announced by CBDT, CII for F.Y. 2017-18 was 272. Hence on assumption CII for F.Y. 2018-19 has been taken at 290. CII for 2013-14 was 220).
B) Without indexation: The cost of acquisition of share shall be higher of the actual cost of acquisition or the highest trading price as on January 31, 2018 which is Rs 962. Hence, the LTCG gain without indexation in such case shall be Rs 38 (1000-962).
Therefore, going by the above example, it can be stated that whether withdrawal of Indexation would result in any loss or gain to all investors , would vary from one stock to another , depending on the price of the Equity as on 31st January 2018, when the Sensex closed 68.71 points lower at 35,965.
The panic in the market due to reintroduction of LTCG tax led the Sensex to fall 839 points on February 2.
Applicable date of LTCG Tax
The tax comes into force from April 1, 2018 and grandfathering can just be meant to assume that the minister proposed it for capital gains availed before January 31, 2018, the preceding day of the Budget speech day. Jaitley wanted to give a message to the investors the government intended to protect them from tax with immediate effect. But he avoided mentioning the actual date of tax levy which is April 1, 2018 to minimise the effect of the announcement on investors.
Here is the catch.
The LTCG tax has been announced in Finance bill 2018 with a new section 112A. Finance Bill contains proposals of govt for new taxes, changes in and continuance of tax structure. The Bill has to be passed by Parliament within 75 days of its introduction in order to become a law.
The exact text of the bill is given below.
"The proposed new section 112A provides that where the total income of an assessee, includes any income chargeable under the head "Capital gains", arising from the transfer of a long-term capital asset, being an equity share in a company or a unit of an equity oriented fund or a unit of a business trust, subject to the conditions specified under the section, the tax payable by the assessee on the capital gains exceeding one lakh rupees shall be calculated at the rate of ten per cent."
Also the Finance Bill is always applicable from the next assessment year that is 2019-20.
Hence, taxation of LTCG is not with immediate effect but with prospective (April 1, 2018) effect according to the date of Budget speech on February 1.
Another logic behind the prospective date of LTCG tax is the large-scale selling in markets on Friday. 839 points were shaved off from Sensex a day after LTCG tax was imposed.
Had the tax come into effect from January 31, 2018, the market would not have seen any selling since investors would have suddenly found themselves on the brink of tax on the current and the next trading day with no escape route which could have led to panic selling. There would have been no point of any panic selling and investors and traders would have been busy doing their LTCG tax calculations.
High market level
The FM chose to tax the market at a right time when valuations were very high and the market was booming, which means the rise in stocks did not reflect the real position of the firms. Instead, the prices were rising on better Q3 earnings hope, and high expectations of farm sector focus in Budget. I feel this was the right time to impose tax on equity transactions and bring back the market to its actual level.
This can be compared with demonetisation which was announced on November 8, 2016 when the GDP growth in the preceding quarter (Q2 of 2016) was 7.3 percent. PM Modi would have accounted for the healthy growth before withdrawing currency notes from the economy.