Implication of Indexation of New Finance Act on Long & Short Term Capital Gain

ABSTRACT

The paper analyzes the impact of the newly introduced indexation rate in the newly introduced Finance Act of India on long-term and short-term capital gains tax computations. Indexation, a critical tool, modifies the cost of an asset for inflation, which subsequently influences the taxable gains elicited from the disposal of that asset. The analysis includes how revised indexation rates affect personal and institutional investment tax obligations and decide their strategies and general financial planning. By juxtaposing the new provisions with previously established tax provisions, the paper highlights substantive changes in tax treatment, especially with respect to long-term capital gains, where favorable indexation concessions allowed for lower tax values. Conversely, a discussion of the considerations that relates to the short-term capital gains tax, which are often assessed at higher rates, is also done in order to explore how this contrasting treatment affects investor behavior. The research also explores certain tax-planning tendencies displayed by some Commonwealth countries for the lessons that can be inferred from their use in the Indian constellation. It tackles important questions regarding how the modification of indexation affects investment, tax planning, and market behavior broadly. The current study states that with the introduction of the new indexations, modifications to tax strategies must be made to construe suitable means to arrive at the least tax liabilities. More importantly here, the study points to the need for informing taxpayers with any changes in the Capital Gain Tax legislation and how such changes bear broader implications for the economy.

INTRODUCTION

Capital gains are the gains derived from selling an estate-farm, stock, real estate business, or other economic asset. Long-term capital gains (LTCG) and short-term capital gains (STCG) in relation to India are broadly classified by the holding period that an asset is kept before being sold again. In many instances, long-term capital gains are always taxed under lower rates and benefit from indexation. Indexation adjusts an asset’s purchase price when paid against the multiplier for inflation. This is crucially important because it shows the taxpayer is not punished by inflationary gains, making the tax system more equitable. The yearly Finance Act of India last year made a few drastic changes in the indexation rates associated with capital gains, thus changing tax liabilities for investors. For instance, suppose that an investor bought property at a cost of ₹50 lakhs in 2010. If he sells the property in 2023 for ₹1 crore, without indexation, the capital gain would then be ₹50 lakhs, which could lead to huge tax liabilities. On applying indexation-CPI to account for inflation, the investor can or shall adjust the cost of the property accordingly to reflect real value for different times. Assuming a cumulative inflation rate of 50% in this regard, the means of meeting the whole value of acquisition would be ₹75 lakhs (₹50 lakhs + 50% of ₹50 lakh). In real terms, this means the capital gains thus liable to tax would be limited to ₹25 lakhs (₹1 crore – ₹75 lakhs). This adjustment would actually cut down the tax burden for the investor drastically. Multiple situations could arise due to these changes in the indexation rates. The new net capital gains-loan loss rate shows LTCG in more attractive light when making investments. This usually disarms the possibility of widespread impractical attacks through inflated goods and commodities. Understanding the intricacies of the finance legislation and how it influences capital gains is crucial, for tax planning strategies to be successful. Investors need to adapt to these modifications in order to manage their tax responsibilities efficiently while also making informed choices. This document seeks to delve into the consequences of the updated indexation rate on capital gains over time frames. Term and short term. Revealing insights, on how these adjustments impact investor actions and the broader market dynamics. In depth research aims to offer insights, for both corporate investors in light of the changing tax environment, in India.

RESEARCH OBJECTIVES

This study’s overall ambition is to assess the impact of the indexation rate which has been implemented in the latest Finance Act of India on the taxation of long-term and short-term capital gains. This study aims to achieve several specific objectives:

• Examine the Changes in Indexation Rate: In order to represent an introductory explanation of the alterations in the indexation rate as stated in the new Finance Act and how it is different from the previous regulations proposed. It is possible to determine those modifications that have influence on capital gains taxation only if understanding these changes.
• Analyze the Impact on Long-Term Capital Gains (LTCG): On this understanding, this paper aims to establish a visual depiction of how the change in indexation rate impacts the taxation of long-term capital gains. This entails also analyzing the advantages under the assumption that that investors who have long term assets are better off compared to others and how this helps in making decisions.
• Evaluate the Effects on Short-Term Capital Gains (STCG): In order to analyze how the new indexation rate affects short term capital gains especially in comparison to LTCG. This situation is important to know for the active traders because they are more likely to be a victim of the absence of indexation gains.
• Investigate Investor Behavior: In that way, to demonstrate the impacts of changes in indexation rates on investors and strategies for their investment plans. This relates to analysis of whether indexation provisions make investors more inclined to undertake long-term investment.
• Compare Tax Planning Strategies: The objective is to analyze and categories strategies underlying tax planning as applied to indexation provisions by investors. This encompasses a study of cases in India and a comparative analysis with the other Commonwealth countries.

RESEARCH QUESTIONS

• How does this new indexation rate affect the taxes chargeable on long term capital gains?
• What relationship does the distribution of the indexation rate have to do with the influence on short-term capital gains?
• What is then left is to see what tax planning strategies can be derived from these changes?

IMPLICATION OF TAX PLANNING

This means that tax planning entails positioning of a given taxpayer in the best strategic position by observing the law most closely with a view of reducing amount of tax to be paid as much as possible. The tax structure in India is relatively quiet exhaustive due to the multiple kind of taxes, for example income tax, capital gain tax, goods and service tax, among others. Within this context, effective tax planning would result in significant tax savings, especially in view of the new changes brought about to the capital gains tax regime under the recent Finance Act.

Importance of Tax Planning:

Tax planning allows individuals and businesses to organize their business affairs in a tax-efficient manner One aspect where tax planning is a must-do item for investors across asset classes, be they participants in the capital markets or real estate, is under­standing capital gains tax. Especially in light of the new Finance Act of 2022, understanding how India’s capital gains regime works with respect to inflation is important for investors trying to maximize their returns on their tax-paid gains. The new tax provisions give a stark indication of the importance of tax planning. By tweaking the indexation loadings, taxpayers obtain the benefit of adjusting the acquisition cost for inflation, or to put it logically, allowing the accrued inflation in an asset to be added to the acquisition cost to arrive at a balancing effect on one’s overall tax liability. Under the new provisions, the indexation adjustment is expected to make a huge positive impact on an investor’s taxable income. Considering that LTCG taxes are generally lower than conventional tax rates, factoring in inflation for computing the taxable gain would almost halve the taxable income, leading to a reduction in tax liability. Let’s take an example of an asset held by an individual for more than three years. With or without indexation, a capital gain from this asset would be taxable. Indexation would, however, increase the tax-free component in the capital gain, which can help in reducing the overall tax liability. Existing research shows that investors may get around the issue of illiquidity by extending the holding periods, thereby mitigating market fluctuations in the short term to some degree.

Tax Planning Techniques:

• Understanding the General Tax Structure: Understanding the Indian tax system is the stepping stone for proper tax planning. Investors updated with variations in STCG vs. LTCG and the taxes owed on both STCG is taxed at the income tax rate of the individual, but LTCG above a certain limit have fixed rates on it. Such understanding is what enables investors to determine the exact period when they should sell their assets.
• Utilizing Indexation Benefits: Since indexation is a crucial factor to minimizing the capital gains tax, the taxpayers need to be very cautious with the time they dispose off their assets. An organ holding an asset for a longer duration can gain preferential advantage through indexation. More information and data should be collected periodically so that appropriate time can be chosen by the investor to sell out the H shares.
• Portfolio Diversification: Another aspect of tax planning is therefore diversification of investments and assets. Diversification of investments may involve putting funds in stocks, bonds, property and so on; investors can also compare tax treatments of the different types of investments. It also differs from the case of other asset classes because each class can have its tax treatments and tax efficient diversification strategy.
• Engaging Professional Help: Due to the high level of sophistication in the tax system few individuals and organizations may find it ideal to seek the services of tax consultants or other financial consultants. These experts can share information of legal tax saving tools like ELSS or PPF which offer the tax advantages along with the possibilities of getting good returns. Regular Review of Tax Positions: Due to dynamic evolution of tax laws and regulations it becomes very often to review them and make changes in the tax planning. Reading parliamentary bills of changes like the new changes in the Finance Act concerning capital gains is important when making investment decisions.

CAPITAL GAINS

Capital gains income is therefore any income that is received from a sale of a “capital asset.” This capital gains are subjected to tax in the year of sale of the capital asset. We refer to this as capital gains tax. This classification is important because it defines the tax rates and the strategies of tax planning in relation to a particular class.

Short Term Capital Gains (STCG):

The gains arising out of sale of an asset are categorized by the period of time held, specifically for the period of less than three years for most kinds of assets which is one year in case of equity shares / mutual funds. STCG are attract tax at the statutorily prescribed income tax rate prevailing to the individual. For instance, in the STCG is earned by a taxpayer who comes under the 30% income tax slab, the profits derived will be taxed at 30%. This implies that the total profit is subject to be taxed unlike in other systems that allow indexation benefits for investors carrying out short-term trades, therefore subjecting the investor to much higher taxes. This higher rate can limit the preferred frequency of trading and make the investors think of holding periods. For listed equity shares, a unit of an equity-oriented fund, and a unit of a business trust, the tax on short-term capital gains has increased from 15% to 20%. The tax at slab rates will still apply to other short-term held financial and non-financial assets.

Long Term Capital Gains (LTCG):

On the other hand, long-term capital gains occur when any capital asset is sold where the asset has been held for more than three years or twelve months in case of equity share/listed mutual fund. One more important benefit that can be obtained by using LTCG is an indexation of acquisition price, which allows to take into account inflation. For example, an investor buys an immovable property for ₹50 lakhs and sells it five years down the line for ₹1 crore; the indexation actually helps in raising the cost of purchase thus bringing down the taxable value added. If, by the use of adjustments for inflation, the cost base rises to ₹75 lakhs, the taxable gain reduces to ₹25 lakhs thereby reducing the tax burden significantly. The annual cap on the exemption of long-term capital gains from business trust units, equity shares, and equity-oriented units has been raised from Rs. 1 lakh to Rs. 1.25 lakh. On the other hand, the tax rate has gone up from 10% to 12.5%.

ABOUT INDEXATION

In taxation, indexation refers to a way of accruing the purchase price of an asset in a bid to prevent excessive assessment of tax on artificial inflation that does not in any way impact the value of the asset. In the case of CAT, indexation provides for an adjustment of the cost of an investment when calculating taxable gains from the disposal of the investment. It becomes especially valuable for investors when this adjustment is applied to long term capital gains (LTCG) where assets are held for long time and resultantly, are affected by inflation. As per the new amendment made in Finance Act in India the indexation is allowed for acquisition cost of an assets and for real computation of actual capital gain. The indexation rate is computed using the cost inflation index (CII), an index, prepared by the Indian government and released on an annual basis.

How Indexation Adjusts for Inflation:

Indexation reduces the amount of inflation within capital gains for it adjusts the actual price at which you bought the asset. For example, if an asset was bought for ₹50 lakhs in 2010, and the cumulative inflation rate over the holding period is 50%, the indexed cost of acquisition would be calculated as follows:

Indexed Cost = Original Cost × (CII of Year of Sale / CII of Year of Purchase)

Illustrations:

To elaborate this more, let’s consider other example of STCG of Rs. 10,000/- on sale of shares. Consider another scenario involving short-term capital gains (STCG). If an asset was bought for ₹30 lakhs and sold within a year for ₹45 lakhs, the gain is:

Capital Gain = ₹45,00,000−₹30,00,000 = ₹15,00,000

Contrary to the above mentioned methods in case of STCG no such indexation is allowed and the whole of amount is taxed at the income tax rate.

In the case of LTCG, the role of indexation can significantly alter the tax amplitude completely neutralizing investors’ tax on offer. This underlines a need to pay attention to an indexation since it might impound the long term investment decisions and in the wake of new Finance Act that would improve both the total financial outcome for the investors.

COMPARATIVE ANALYSIS

Comparing New Indexation Rates with Previous One:

New changes in indexation rate which have been passed in the Finance Act of India have shown many changes compare to previous rate. Earlier, Cost Inflation Index (CII) was revised from time to time, but in small portions and not in conformity with actual inflation rate for longer time span. For instance, in the past low levels of inflation gains would not sufficiently protect those with long term securities when the CII was increased moderately. The new indexation provisions are intended to provide a better adjustment for the taxpayers in regards with the issue of the inflation. This leads to higher acquisition costs reflected in the account by increasing the indexing of these costs and therefore lower taxable gains through sale of the assets. For instance, CII adjustments in the past may have cost $30 to bring about a 10-year period while the new regime will only be $50, a suitably more accurate inflation rate which will cut down on tax on other long-term capital gains.

Analysis of the Impact on Tax Liabilities for Different Investor Profiles:

The consequences of such changes in the indexation rates differ from investor to investor and company to company. The government decision on new indexation rate has reward the long term investor; the pensioner and the conservative investor who holds long term portfolio. Many of these investors can thus significantly reduce their tax liabilities by raising the cost base of their investments, thus being able to keep more of their investment earnings. For instance, an investor who entered into an investment costing 50 lakhs and finds, after the onslaught of this new indexation, that the original cost has gone up to 75 lakhs, is only liable to tax on the actual profit earned over and above this new presumed cost. Contrary to this expectation, short-term traders or others actively in the market may not see much difference with the new indexation as STCG attracts taxes at the normal rates with indexation. Their taxation rules continue to depend mainly with the frequency of their trades and the level of the income tax they are likely to pay under the existing tax laws; therefore, the need to exercise so much caution when undertaking the trades saving for the tax implications that come with it.

Examination of Equity and Fairness in the Application of the Indexation Rate:

Concerns connected with equity and fairness in the taxation system can be raised with the help of the application of the new indexation rate. Another advantage of indexation is its role of furnishing long-term investors a base with which their gains are indexed or the performance of their investment portfolios adjusted for the inflationary trends. This is particularly convenient in an economy like India’s where inflation proves to be volatile in some periods. But there seem to be room for inequity, particularly from the aspect of financial competency of different investors. Thus, it can be hypothesized that high-net-worth investor or institutional investor, who in turn seem to be able to more often and more easily retain assets in the long term, will receive greater benefit from indexation provisions rather than the retail investor or individuals with a need to convert their assets into cash quickly. Furthermore, the centre of attention on the generation of long-term capital gains may, in fact, harm shorter-term investments and reduce market turnover.

BEST PRACTICES FOLLOWED IN COMMONWEALTH NATIONS

In tax legislation, tax management is critical for investors in influencing the way capital gains are taken care of by investors in the Commonwealth nations. So, it cannot be out of context to understand how the Commonwealth countries address the capital gains taxation and the practical strategies that concerns the Indian investors.

Indexation Practices:

Now the majority of the countries within the Commonwealth – Australia, Canada, the United Kingdom – have introduced some procedures associated with indexation or inflationary adjustments into the legislation on capital gains tax. For example, up to 2002, Australia previously used an indexation system whereby the cost base of an asset could be inflated where it was held for more than 12 months. Such practice offered a fairer distribution in the gains throughout the holding period thereby using economic reactivity as an indicator of tax imposition instead of the nominal value changes. AUSTRALIA has since adopted this method for new assets; nevertheless, the exercises of indexation form part of alterations in current tax planning.

Tax Incentives and Exemptions:

Commonwealth countries use numerous tax incentives to attract investment as will be described below. The investors in United Kingdom for instance are well protected by an annual exempt amount wherein they can sell their shares and accept a capital gain up to some extent without paying tax. This exception is especially helpful for those who invest petty amounts or persons with small investments in the market to increase market participation. In Canada these strategies include tax-loss harvesting where one uses a loss in a particular investment to offset gains in other investment. This approach lowers adjusted gross income of investors and influences proper management of investments especially during periods of high risk.

Taxation and its relation to the concept of Equity and Fairness:

The other principle, which is fairly used in many Commonwealth countries, is equity and fairness in tax policy. The state and federal governments work with the public so that they do not burden the “little guy” when they implement capital gains taxation. These nations wish to foster fair taxation since an open discussion of the issue will help arrive at formulas that allow for fair taxation as a way of enhancing economic growth.

CONCLUSION

The introduction of the new indexation rate under the newly amended Finance Act, would be deemed a substantial change that has amplified the trends in capital gains taxation most especially to ‘long term and ‘short term’ capital gain dealers. In this respect, the new provisions have intended to balance the taxation structure towards better and fair indication of real economic gains by providing for inflation dealings in the computation of capital gains. This is good news to long term investors as they struggle through inflation especially when holding their stakes for long periods. Indexing the cost of acquisition itself can help reduce the taxing of such benefits significantly, let the investors retain more of their profits which in turn shall promote the spirit of long-term investment. In addition, the distinction separating LTCG and STCG remains relevant when designing investment approaches. The preferential tax treatment of LTCG is again empowering the long-term investors like stability in the financial market is favored. By contrast, STCG, which is taxed at a higher marginal rate, may discourage frequent transactions and speculative operations, which indeed may lead investors to exercise a rational view over their portfolio. However, much of what indexation entails also generates essential questions on equity and efficiency of the tax policy. It is one of the benefits of the new provisions to long-term investors although there is a probable disadvantage of the position of lower income or less informed investors if they cannot invest for a long term. Government and its agencies need to guarantee that any changes made with regards to taxation laws, do contain the necessary safeguards and benefits for every class or stratum of investors.

Therefore, it can be said that there are possibilities that the new indexation rate alters the investment dynamics in India for wealth creation over a long term and to attain better tax equity. To the investors, the changes are important for properly computing tax implications to strategies and plans for investment. Such changes are underway in India and it becomes important to focus on the reforms such that equitable taxes will support a strong capital market to ensure that economic development is steady.

References

• https://cleartax.in/s/capital-gains-income
• https://indianexpress.com/article/business/indexation-benefit-withdrawal-on-grandfathered-debt-mutual-fund-investments-has-investors-worried-9489986/
• https://www.investopedia.com/terms/i/indexation.asp
• https://www.investopedia.com/terms/i/indexation.asp
• https://www.tdecu.org/wealth-advisors-blog/six-basic-tax-planning-techniques

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Author: Sarthak Sharma| Students, University of Petroleum & Energy Studies (UPES), Dehradun, School of LAW, 4^th Year, Course BA LL. B(Hons) specialization in Taxation Law. Email: sarthakshm5955@gmail.com.