Navigating through the complex changes in the taxation of capital gains on listed equity shares
On February 1, 2018, the long running tax-free party for equity investors finally met its pooper. Budget 2018 imposed 10 per cent tax on long-term capital gains (LTCG) above ₹1 lakh a year on listed equity shares and equity mutual funds. This tax kicked in from April 1, 2018. It has a wide impact — not just on
regular equity sales, but also on sales in special situations such as bonus shares, rights shares, buybacks, stock splits, mergers and demergers.
The big switch
Simply put, capital gains on equity is its selling price minus its cost of acquisition. Until March 2018, LTCG on listed equity shares and equity mutual funds were exempt from tax. So, if you sold these shares and mutual fund units after holding them for more than 12 months from the date of acquisition, the gains were considered long-term and no tax was levied on them. Gains on equity and equity mutual funds held for 12 months or less (short-term capital gains) were taxed at a concessional rate of 15 per cent. This preferential tax treatment was around since 2004 when the securities transaction tax (STT) was introduced in tandem with the concessional tax treatment on equity investments. But like all good things, this too has come to an end.
From fiscal 2018-19, LTCG arising from transfer of such equity shares and equity mutual funds exceeding ₹1 lakh a year will be taxed at 10 per cent. The tax exemption on gains up to ₹1 lakh is to shield small investors.. Short-term gains continue to be taxed at 15 per cent. The Government has given another key concession for all investors — the ‘grandfathering’ clause on LTCG to soften the tax blow..
On sales from April 1, 2018, LTCG on listed equity up to January 31, 2018 will be grandfathered, that is, they will continue to be exempt from tax, and only LTCG made after January 31, 2018 will be taxed. This significant concession is enabled by the formula to determine the cost of acquisition — Higher of a) actual cost b) lower of i) fair market value on January 31, 2018 ii) selling price. The fair market value on January 31, 2018 is the highest intra-day traded price for listed equity shares, and net asset value of mutual funds on that day.
The formula does two things. One, it exempts from tax the LTCG made up to January 31, 2018. Next, it prevents the anomalous situation of long-term capital loss and (consequently lower tax) in cases where the selling price is lower than the value as on January 31, 2018 but higher than the original cost price. (See Table 1 for LTCG scenarios)
Once the LTCG is determined, gains in excess of ₹1 lakh a year will be taxed at 10 per cent. Surcharge on tax, if applicable, and cess on tax-plus-surcharge at 4 per cent will also apply. Indexation of cost of acquisition that factors inflation over the holding period of the investment, is not allowed in the case of LTCG tax on equity. There will be no tax deduction at source (TDS) on such LTCG and the investor is responsible for paying the tax.
Long-term capital loss arising on sale made on or after April 1, 2018 will be allowed to be set off and carried forward for eight years as per the tax rules. Until March 2018, there was no provision for set-off and carry forward of long-term capital loss on equity, since there was no tax on LTCG.
Against this backdrop, here’s how the tax game plays out in the sale of listed equity shares in special situations. Like before, the key aspects that determine the tax liability include the sales price, cost of acquisition, whether the gain is long term or short term, based on the period of holding, and the tax rate.
Bonus shares
A company issues bonus shares, free of cost, to its shareholders by transferring amounts from its reserves to equity capital. Bonus shares are issued in a certain ratio, say, 1:1 (1 bonus share for 1 share held by the shareholder). After the bonus issue, the stock price generally adjusts based on the bonus ratio, say, 50 per cent in the above example.
Until Budget 2018, the cost of acquisition of bonus shares was considered nil and, thus, the entire sales proceeds became the capital gains. The period of holding is calculated from the date of allotment of the bonus shares, not from the date of acquisition of the original shares. If long term, the bonus shares were exempt from capital gains tax and, if short term, the tax rate was 15 per cent of the gains.
After Budget 2018, the cost of acquisition of bonus shares will remain nil if the holding period is short term and tax at 15 per cent will continue. But if long term, the cost of acquisition of bonus shares acquired before January 31, 2018 will be computed, as per the formula laid down by Budget 2018. So, if higher than the actual cost of acquisition but lower than the selling price, the fair market value as on January 31, 2018 will be considered as the cost of acquisition. The effect: on sales from April 1, 2018, the LTCG accrued up to January 31, 2018 will continue to be exempt from tax, but LTCG made thereafter will be subject to tax at 10 per cent.
For bonus shares issued after January 31, 2018, the cost of acquisition will be nil — both for short-term gains and long-term gains computation. (See Table 2 for scenarios on tax on sale of bonus shares)
An illustration
Say, you bought 100 shares of company A in April 2016 at ₹200 a piece, were allotted 100 shares as bonus in April 2017, sold all the 200 shares in August 2018 for ₹300, and the fair market value of the shares as on January 31, 2018 was ₹250. The gains on both the original and bonus shares will be long term in nature, having been held for more than 12 months since allotment. The LTCG on both the original 100 shares and 100 bonus shares will be ₹50 (300 – 250) per share. The tax rate will be 10 per cent.
Now, say, you purchased 100 shares of company A in April 2016 at ₹200 a piece, were allotted 100 shares as bonus in December 2017, sold all the 200 shares in August 2018 for ₹300, and the fair market value of the shares as on January 31, 2018 was ₹250. The gains on the original shares will be long term in nature, as they have been held for more than 12 months since allotment. But the gain on the bonus shares will be short term as they have been held for only nine months. The LTCG on the original 100 shares will be ₹50 (300 – 250) per share and the tax rate will be 10 per cent. The STCG on the 100 bonus shares will be ₹300 (300 – nil) per share and the tax rate will be 15 per cent. Note that the cost of acquisition for the bonus shares in this case is nil and not ₹250, even though they were allotted before January 31, 2018; that’s because the gains are short-term in nature.
What if the bonus shares, in the example above, were issued in April 2018 and sold in August 2018? Here too, the gains would be short term as the shares have been held for only five months, the cost of acquisition will be nil, gains will be ₹300 (300 – nil), and it will be taxed at 15 per cent.
Now, what if the bonus shares were issued in April 2018 and sold in May 2019? Here, the gains would be long term, as the shares have been held for over 12 months. Cost of acquisition will be nil as the shares have been issued after January 31, 2018. The gains ₹300 (300 – nil), will be taxed at 10 per cent.
Rights shares
Rights shares are issued by a company to its existing shareholders at a price lower than the prevailing market rate. Like bonus, it is also issued in a ratio of the original shareholding, say 1:5 (one1 rights share for five shares already held). The tax treatment of rights shares is also similar to bonus shares in most aspects — including the calculation of period of holding from the allotment date, the tax rates and tax treatment, pre-Budget 2018 and post-Budget 2018. But there is an important difference — the original cost of acquisition is nil in a bonus issue, while for a rights issue, it is the price paid to subscribe to the issue.
If the gain is long term, the cost of acquisition of rights shares acquired before January 31, 2018 will be computed as per the formula laid down by Budget 2018. So, if higher than the original cost of acquisition but lower than the selling price, the fair market value as on January 31, 2018 will be considered as the cost of acquisition. The effect: on sales from April 1, 2018, the LTCG accrued up to January 31, 2018 will continue to be exempt from tax, but LTCG made thereafter will be subject to tax at 10 per cent. If short-term gains, the cost of acquisition of rights shares will remain the price paid to subscribe to them, and tax at 15 per cent will continue. In the case of rights shares issued after January 31, 2018, the cost of acquisition will be the price paid to subscribe to them — both for short-term gains and long-term gains computation. (See Table 3 for scenarios on tax on sale of rights shares)
Illustration
Assume you bought 100 shares of company B for ₹500 a piece in January 2015, were issued 20 rights shares in January 2017 at ₹600 (when the market price was ₹750), sold all the 120 shares in May 2018 at ₹1,000, and the fair market value as on January 31, 2018 was ₹800. The gains on both the original and rights shares will be long term in nature, as they have been held for more than 12 months since allotment. The LTCG on both the original 100 shares and 20 rights shares will be ₹200 (₹1,000 – 800) per share. The tax rate will be 10 per cent.
Now say, you bought 100 shares of company B for ₹500 a piece in January 2015, were issued 20 rights shares in October 2017 at ₹600 (when the market price was ₹750), sold all the 120 shares in May 2018 at ₹1,000, and the fair market value as on January 31, 2018 was ₹800. The gains on the original shares will be long term, as they have been held for more than 12 months since allotment. But the gains on the rights shares will be short term in nature as they have been held for only eight8 months. The LTCG on the original 100 shares will be ₹200 (₹1,000 – 800) per share and the tax rate will be 10 per cent. The STCG on the 20 rights shares will be ₹400 (1,000 – 600) per share and the tax rate will be 15 per cent.
What if the rights shares, in the example above, were issued in April 2018 at ₹600 and sold in May 2018 at ₹1,000? Here too, the gains would be short term as the shares have been held for only two months, the cost of acquisition will be ₹600, gains will be ₹400 (₹1,000 – 600), and it will be taxed at 15 per cent.
Now, what if the rights shares were issued in April 2018 and sold in May 2019? Here, the gains would be long term as the shares have been held for over 12 months. Cost of acquisition will be ₹600 as the shares have been issued after January 31, 2018.. The gains ₹400 (₹1,000 – 600), will be taxed at 10 per cent.
Buyback of shares
In a buyback, companies repurchase shares from shareholders. It is a way of returning excess cash to shareholders. Buybacks can happen through the market mechanism on the stock exchange or directly through off-market deals outside the stock exchange.
When shares are bought back directly through off-market deals, they are not subject to securities transaction tax (STT) and do not enjoy any concessional tax treatment. So, short-term gains are taxed at the investor’s slab rate (5 per cent to 30 per cent), while long-term gains are taxed at 20 per cent with indexation or 10 per cent without indexation.
When buybacks happen through the stock market mechanism, they are subject to STT and enjoy concessional tax treatment. So, short-term gains are taxed at 15 per cent, while LTCG on buybacks from April 1, 2018, are taxed at 10 per cent based on the Budget 2018 formulation. The period of holding is considered from the date of allotment of shares that are bought back. The sale consideration is the price at which the shares are bought back. If the gains are long-term in nature, the fair market value, as on January 31, 2018 will be considered as the cost of acquisition if it is higher than the original cost of acquisition, but lower than the selling price. This benefit of enhanced cost of acquisition is not there if the gains are short-term in nature.
Illustration
Say, company C offers to buy back 100 shares from you at ₹2,000 in August 2018. These shares were originally acquired by you in July 2017 at ₹1,000 and the fair market value as on January 31, 2018 was ₹1,500. If you tender your shares in the buyback through the stock market mechanism, the gains will be considered long-term as the shares have been held for more than 12 months. The LTCG will be ₹500 a share (₹2,000 – 1,500) and it will be taxed at 10 per cent.
Now, in the above example, if you had acquired the shares in January 2018, the gains will be short term as the shares have been held for less than 12 months. Here, the cost of acquisition will only be ₹1,000 and not the fair market value of ₹1,500 as on January 31, 2018. So, the short-term capital gain will be ₹1,000 (₹2,000 – 1,000) and it will be taxed at 15 per cent.
Ambiguities remain
Under the new tax regime, there is lack of clarity on what should be considered as the cost of acquisition in some other special cases such as mergers/amalgamations, demergers, gifts/ inheritance/will, and stock splits/consolidations, when these shares are sold.
Will the formula laid down by Budget 2018 apply in these cases too or will the original cost of acquisition, as laid down by various other sections of the tax law, continue to be applicable? Shareholders would prefer the formula laid out in Budget 2018 to be applied in these special situations too as that would exempt from tax the LTCG up to January 31, 2018 on the sale of these shares. But the matter seems open to interpretation.
Amit Agarwal, Partner, Nangia Advisors LLP says, “There are several ambiguities with respect to the methodology of calculating taxable long-term capital gains, especially in the context of tax-neutral corporate actions.”
Let’s consider a case of amalgamation in which company A is merged into company B. The shareholders of company A will receive shares of company B. The tax law provides that for the investor now holding shares in company B, the cost of acquisition will be the cost that was originally paid to acquire shares in company A. Now, when the shares of company B are sold, the law does not give the flexibility to use the cost of acquisition formula laid out by Budget 2018. If the original cost of acquisition is used to compute LTCG, the tax incidence could be higher than if the January 31, 2018 price were to be used as the cost of acquisition.
In a demerger, shareholders of the demerged company receive shares of the resulting company too, and the cost of acquisition is apportioned on the basis of net book value of the entities. But the law does not provide for the split of the cost of acquisition of these companies arrived at using the Budget 2018 formula.
In a transfer by inheritance/gift/will, the law says that cost of acquisition to the new owner will be the cost to the previous owner. On sale by the new owner, there is scope for ambiguity because the law currently does not provide the flexibility of using the Budget 2018 formula to arrive at the cost of the acquisition.
In the case of stock splits/consolidations after January 31, 2018, on the sale of these new securities, the tax authorities could possibly deny the benefit of the cost of acquisition using the Budget 2018 formula.
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