For representative purposes. | Photo credit: Getty Images
The story so far: Finance Minister Nirmala Sitharaman’s announcement in the Union Budget on doing away with indexation for calculating long-term capital gains tax (LTCG) has not attracted much attention. They have proposed that long-term gains in all financial and non-financial assets will now be taxed at 12.5% instead of a tiered structure, even ignoring indexation. A memorandum explaining the provisions of the Finance Bill (2024), states that this is to “facilitate the calculation of capital gains for taxpayers and tax administration”.
What is the purpose of indexing?
Imagine, a person buys a house for ₹10 lakh in 2001. For reasons such as inflation and/or a vibrant property market, he may sell the same property in 2021 for ₹75 lakh. Here, it may be seen that he earned ₹65 lakh and has to pay tax on it.
However, these figures do not take into account the price level that existed at the time of sale versus purchase. This is where the Cost Inflation Index (CII) comes in. Indexation ensures that taxpayers are taxed on real income from income at current prices, which is the result of a general increase in prices, and not economic growth, during the course.
In the example, the CII for 2021 (ie, 317) would be divided by the base year of 2001 (100) to derive the number. It will then be multiplied by the purchase price (ie ₹10 lakh). Accordingly, the indexed expenses came to ₹31.7 lakhs and the individual taxable profit was revised down to ₹43.3 lakhs. At the previous rate of 20%, it now has to pay long-term capital gains tax of around ₹8.7 lakhs. But under the new system, ₹65 lakh will be taxed at 12.5%. So, the tax liability is ₹8.13 lakh.
What is the problem?
Abhijit Mukhopadhyay, a consulting economist at the Secretariat explained The Hindu that the tax liability is finally widely determined by two factors, that is, the rate of return and subject to time-period.
In this regard, it is important to note that not all assets can experience the same exponential growth as in the example above. This may be due to a flat market or a temporary slump period. This is mainly where indexing gets better. To illustrate, let’s say that in 2021 instead of ₹75 lakh, the house is sold for ₹40 lakh. If adjusted with indexation, the tax liability is ₹1.66 lakh as against ₹3.75 lakh without indexation.
Further, a BankBazaar study, based on an assessment of the RBI’s House Price Index, observed that without indexation, the LTCG tax would have tripled on properties purchased after 2010. Keeping the base year as FY 2010-11, the study noted a “severe loss of savings tax” especially in 2016-17. “From zero tax liability across the board, we see significant liability in these years (since 2016-17),” the study found. The Income Tax Department, however, estimates that real estate returns (12-16% per year) are higher than indexation for inflation (4-5%), depending on the holding period. Therefore, it predicts “substantial tax savings” to the “majority” of taxpayers.
According to Mr. Mukhopadhyay, people will benefit more from the amended provisions if they sell the asset quickly (say, 3-4 years) than hold it for a longer period (say, 10 years or more). Furthermore, he explained that with these changes, real-estate investment trusts (REITs) and infrastructure funds continue to suffer because they “don’t have the same rate of return as the equity market”. On bonds, Anil Talreja, Partner at Deloitte India, said the feedback has been “rather muted” due to the lack of indexation. “That’s why this can lead to the popularity of these instruments,” he said.
What does this mean for assets?
According to Mr. Talreja, while the removal of indexation “adds moisture” to the overall sentiment, the reduction in the basic tax rate provides a “balance of moisture”. He explained, “A lot depends on the nature of the asset, the time when the asset was purchased (during a price boom or something else). Based on this, it will continue to cause different reactions from different parts of society.
As for real estate, Mr. Mukhopadhyay observed that people who want to buy a second home for investment purposes may not do so. “They should sell if they can quickly make a profit from the revised provisions,” he said. But the paradigm can be minimized, according to him, for those who want to buy a house to live. It is important to note here that the Income Tax department clarified that for assets acquired before April 1, 2001, the individual will have the option to choose between the fair market value on that date (April 1, 2001) and the actual cost of acquiring the asset. as a basis for calculating capital gain in the sale. This paved the way for an indexation cushion for pre-2001 acquisitions.
Another concern that was also raised by AAP MP Raghav Chadha in the Rajya Sabha, included the potential sale of properties at circular rates (the minimum price for selling real estate). Undervaluing real estate helps generate lower capital gains, thus, lower taxes. Furthermore, Mr. Chadha was also warned about the increase in black money transactions in the sector – another way to hide the proceeds.
