Understanding Capital Gains Tax in India: Conditions, Exemptions, and Tax Liability

Capital gains tax is a crucial aspect of the Indian Income Tax Act, 1961, which applies to gains derived from the transfer of capital assets. This article explores when capital gains tax liability arises, the conditions for taxability, and available exemptions under various sections.

What is Capital Gains Tax?

Capital gains tax is a tax on the profit earned from selling or transferring a capital asset. A capital asset can be any property, including real estate, stocks, bonds, or jewelry, held by an individual, company, or other entities. Capital gains tax is levied on the profit gained from the sale, not on the sale amount itself.

When is Capital Gains Tax Applicable?

For capital gains tax to apply, the following conditions must be met:

1. Existence of a Capital Asset: The asset being transferred should be a capital asset as defined under the Income Tax Act. Capital assets include real estate, stocks, mutual funds, and other investments.
2. Transfer of Capital Asset by the Assessee: The asset must be transferred or sold by the assessee (the taxpayer). Transfer includes sale, exchange, relinquishment, or extinguishment of rights.
3. Transfer Takes Place During the Previous Financial Year: The sale or transfer of the asset must have occurred in the previous financial year (FY) before the relevant assessment year (AY). For instance, if a property was sold in FY 2022-23, the tax liability will arise in AY 2023-24.
4. Profit or Gain from the Transfer: There should be a profit or gain as a result of the transfer. The capital gains tax is computed based on this gain, not on the entire sale value.
5. Non-Exemption of Gain: The gain should not be eligible for exemption under sections like 54, 54B, 54D, 54EC, 54EE, 54F, 54G, 54GA, and 54GB. If an exemption applies under these sections, capital gains tax may not be levied.

Key Exemption Sections in Capital Gains

The Income Tax Act provides various sections that allow exemptions on capital gains under certain conditions. Here’s a brief overview:

• Section 54: Applicable for capital gains from the sale of a residential property, provided the taxpayer reinvests in a new residential property within specified timelines.
• Section 54B: Relates to capital gains from agricultural land, with an exemption for reinvestment in other agricultural land.
• Section 54D: Applicable when the capital asset is land or building and was used for industrial purposes, and the transfer is due to compulsory acquisition by the government.
• Section 54EC: Provides exemption for gains from long-term capital assets if the taxpayer invests the gains in specified bonds, such as those issued by NHAI or REC, within six months of transfer.
• Section 54F: Provides an exemption for capital gains from any long-term asset (excluding residential property) if the taxpayer reinvests in a residential property.
• Sections 54G and 54GA: Allow exemptions for businesses transferring assets due to shifting or relocating to notified areas or Special Economic Zones (SEZs).

• Section 54GB: Provides exemption for gains invested in startups, provided the funds are used for purchasing new assets for eligible businesses.

What is Included in Capital Assets?

The scope of “capital asset” is wide-ranging and includes:

1. Property of Any Kind: Capital assets encompass property of all types, whether fixed or circulating, movable or immovable, tangible or intangible. This includes land, buildings, vehicles, and intangible assets like goodwill, trademarks, patents, copyrights, and licenses.
2. Rights Related to an Indian Company: The definition extends to any rights in or related to an Indian company. This includes rights of management, control, or any other rights associated with ownership or control over an Indian company.
3. Property Held by an Assessee: Any property held by the taxpayer (referred to as “assessee”) qualifies as a capital asset, regardless of whether it is related to their business or profession.
4. Securities Held by Foreign Institutional Investors (FIIs): Any securities held by an FII that are acquired under the regulations of the Securities and Exchange Board of India (SEBI) Act are classified as capital assets.
5. Unit-Linked Insurance Plans (ULIPs): A ULIP policy issued on or after February 1, 2021, is considered a capital asset if it does not qualify for exemption under section 10(10D). This applies when the insurance premium paid in any previous year during the policy term exceeds ₹2.5 lakh.

What is Excluded from Capital Assets?

Certain items are explicitly excluded from the definition of capital assets. These exclusions are important because they determine which assets are not subject to capital gains tax.

1. Stock-in-Trade: Items held as stock-in-trade by a taxpayer, such as inventory, are not capital assets. Since these items are part of the business’s regular operations, they are treated differently from capital assets for tax purposes.
2. Personal Effects: Items intended for personal use, such as clothing, furniture, and vehicles (unless they are antiques or collectibles with investment value), are excluded from capital assets. These are considered personal belongings rather than investment assets.
3. Agricultural Land in Rural Areas: Rural agricultural land, based on its location, is excluded from capital assets. This exemption applies to agricultural land that is located outside specific urban areas, as defined in the Act. However, agricultural land in notified urban areas may still be considered a capital asset.
4. Gold Deposit Bonds: Gold deposit bonds issued under the Gold Deposit Scheme, 1999, and similar notified government schemes are excluded from the capital assets category.
5. Special Bearer Bonds: Certain types of bearer bonds notified by the government are also excluded from being classified as capital assets.

Stock-in-trade is not a capital asset

Any stock-in-trade (not being securities held by a Foreign Institutional Investor), consumable stores or raw material held for the purpose of business or profession is not a capital asset. This is because of the fact that any surplus arising on sale or transfer of stock-in-trade, consumable stores or raw material is chargeable to tax as business income under section 28. What shall be included in the term “stock-in-trade” must always be dependent upon the nature of the business of the taxpayer. For instance, if the taxpayer deals in house properties, then such properties are stock-in-trade and, consequently, they are not capital asset. If a dealer in properties transfers his stock-in-trade (i.e., house properties), the resulting profit is business income not capital gains. Conversely, if a doctor transfers a house property, the resulting income is taxable under the head “Capital gains”.

Personal effects (being movable assets) are not capital assets –

Any movable property (including wearing apparel and furniture) held for personal use of the owner or for the use of any member of his family dependent upon him, is not a “capital asset” for the purpose of income under the head “Capital gains”. However, the following are not “personal effects” (in other words, the following are “capital assets”) even if these are for personal use—jewellery, archaeological collections, drawings, paintings, sculptures, or any work of art.

Understanding Short-Term and Long-Term Capital Assets in India

Capital assets are categorized into short-term and long-term based on the duration for which they are held by the taxpayer. This distinction is important because it affects the tax rate applicable to the capital gains earned from these assets.

What is a Short-Term Capital Asset?

A short-term capital asset is one held by the assessee (taxpayer) for not more than 36 months immediately before the date of transfer. If the asset is transferred within 36 months from the date of acquisition, any gain or loss arising from the transfer is classified as short-term capital gain or short-term capital loss.

What is a Long-Term Capital Asset?

If a capital asset is held by the assessee for more than 36 months, it is considered a long-term capital asset. Consequently, any gain or loss arising from the transfer of such an asset is treated as long-term capital gain or long-term capital loss.

Special Cases with Reduced Holding Periods

In certain cases, assets can be classified as long-term if held for a shorter period of 12 months or 24 months. The following categories outline the cases where reduced holding periods apply:

Category A – Holding Period Exceeding 12 Months

For these assets, if they are held for more than 12 months, they are considered long-term capital assets (for transfers made after July 10, 2014):

1. Listed Equity or Preference Shares: Equity or preference shares in a company that are listed on a recognized stock exchange in India.
2. Listed Securities: This includes debentures, bonds, government securities, and derivatives traded on recognized stock exchanges in India.
3. Units of UTI: Units of the Unit Trust of India, whether listed or not.
4. Units of Equity-Oriented Mutual Funds: Units of mutual funds that primarily invest in equities, whether listed or not.
5. Zero Coupon Bonds: Bonds that do not pay periodic interest but are issued at a discount to face value, whether listed or not.

Category B – Holding Period Exceeding 24 Months

For these assets, if they are held for more than 24 months, they are considered long-term capital assets:

1. Unlisted Equity or Preference Shares: For transfers made on or after April 1, 2016.
2. Immovable Property (Land or Buildings): For transfers made on or after April 1, 2017.

How to Determine the Holding Period?

The Income Tax Act provides specific rules for determining the holding period of certain capital assets. For example, the date of acquisition, holding period, and transfer date of securities and immovable property are defined to ensure accuracy in classification.

Why Classify Capital Assets as Short-Term or Long-Term?

The classification of capital assets into short-term and long-term affects tax rates on capital gains:

• Short-Term Capital Gains: Gains from short-term assets are taxed at higher rates compared to long-term capital gains. These gains are typically added to the taxpayer’s income and taxed according to their income tax slab.

• Long-Term Capital Gains: Gains from long-term assets are generally taxed at a lower rate, usually a flat rate of 20% with indexation benefits. Indexation adjusts the asset’s purchase price for inflation, reducing the taxable gain amount.