We look to understand the capital gains tax that is liable on the income you make by selling shares and the possible ways to avoid it. Capital gains, the profit you make on selling your assets, is an income that is liable to income tax. For the purpose of taxation it is called ‘capital gains tax.’ Let us look into how this tax is calculated and what are the ways you can avoid paying capital gains tax.
Short Term Capital Gains Tax Vs Long Term Capital Gains
For the purpose of taxation, the capital gains on selling of shares have been bifurcated into two categories in order to have differential taxation for those who invest for the purpose of safeguarding their savings and those who make the investment as a mode of making an income. Any income made from selling shares held for more than a period of one-year are considered as long term capital gains. Any income made by selling shares held for a period of less than one year are considered short term capital gains.
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Taxation On Short Term Capital Gains
The long term investors, who are investing their savings, obviously enjoy a few more benefits than short term investors. The short term investors are taxed flatly at a rate of 15% of their capital gains.
But, if you have incurred any expenses upon the purchase or sale of the shares, such as brokerage, you are allowed to deduct that amount from the capital gains to lower your tax burden. So the calculation of tax on short-term capital gains would be,
Selling Price – Buying Price of the Stock – Expenses on Purchase or Sale
15% of the capital gains arrived at from this equation will be the amount liable to the tax authorities.
Long-term investors, however, are approached differently in matters of tax on capital gains from selling your shares.
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Taxation on Long-Term Capital Gains When You Sell Your Stock
Up to the year 2018, long-term capital gains were completely exempt from taxation. Any stock or equity held for a period of more than a year can be sold for a profit without being taxed. This move was done to encourage cash liquidity in the markets in order to boost domestic wealth. However, the budget of 2018 decided to take a different approach to this strategy and decided to tax long-term capital gains as well, taxing any capital gains made from investments held for more than a year at 10%.
However, the principle of goodwill in long-term investments remains intact and hence certain exemptions were afforded to long-term investors to avoid long-term capital gains tax.
So let’s take a look at these conditions that make a long-term capital gain exempt from taxation.
Exemptions for Long-Term Capital Gains
First, under section 112A, any capital gains under the value of ₹1lakh is not taxable. So one of the best ways to avoid paying capital gains tax when you sell your stock is to make sure that you keep your capital gains within the exemption bracket. Divesting small and timely is the best way to reap the benefits of your investments.
Second, under section 54F, a long term investor can claim tax exemption if he / she invests the proceeds from the sale of stock elsewhere. But, there are rules as to where you can invest the proceeds. You can channel the proceeds from the divestment in the following manner to gain relief from capital gains tax.
- You can invest in real estate within two years of making the sale in a maximum of two real estate properties as long as the properties remain unsold for a period of three years after purchase
- If you have made an investment in a real estate property within one year prior to the sale of the stock, you can claim deduction of the cost of the investment against the capital gains and get exempted from capital gains tax. Again, the investment in the property has to be held for a period of three years after purchasing it
- You can invest the proceeds in a construction project as long as the construction is completed within three years of making the long term capital gains.
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The taxation on long term capital gains was a major policy decision with possible effects on the mindset of a long term investor who had invested his / her savings with the expectation of avoiding taxes. So the budget also took measures to safeguard the investments of those who had invested their savings in the market to take advantage of the previous regime’s policy by introducing what is known as the ‘Grandfathering Rule’.
The Grandfathering Rule
When the decision to tax long-term capital gains was introduced in the budget of 2018, there was a big concern about creating panic in the stock market. And so, Section 112A was introduced to look into the concerns of those long-term investors who had invested their savings into the stock market before the turnaround in the policy of taxing their long-term capital gains. The investors who had made investments in the stock market prior to 31 January 2018 and were sold before 1st of April 2018 were completely exempted from long-term capital gains taxation. This gave the investors who were unhappy with the decision of taxing long-term capital gains ample time to exit the market and move their savings to an alternative haven. However, those who decided to continue to keep their faith in the stock market and bear the cost of taxation on long-term capital gains were given a slight relief for their continued patronage. Any investor who held long-term investments prior to 31 January 2018 and continued to hold those investments post 1 April 2008 would be given exemption from taxation in the following manner.
Now the universal formula for calculating capital gains is,
Selling Price – Cost of Acquisition
The cost of acquisition usually being the price at which the shares were bought. But to give maximum benefit to the ‘Grandfathering Investors’ the idea was to allow them to enhance their cost of acquisition so as to allow them to seek reduction in the calculation of the capital gains and the consequent reduction in the capital gains tax liability. So, for the purpose of the ‘Grandfathering Rule’, the cost of acquisition for shares that have been purchased prior to 31 January 2018 would be calculated as follows.
First, you first determine the highest quoted value of the stock in the stock market as on 31 January, 2018 and you compare it with the price at which you are selling the stock and select whichever value is lower amongst the two.
Next, you take the value selected in the previous step and compare it with the cost at which you bought the stock. Whichever is the highest amongst these two values is considered to be the ‘cost of acquisition’.
Illustration for the ‘Grandfathering Effect’ on the Calculation of Long Term Capital Gains Tax on Sale of Stock
Let’s say a stock has been bought for ₹10,000 and after a period of 2 years has been sold for ₹15,000. So in order to arrive at the long term capital gains on this transaction, we apply the universal formula of selling price minus buying price. Which is,
₹15,000 – ₹10,000 = ₹5,000
And so the long term capital gains tax on ₹5,000 is calculated at 10%, i.e., ₹500.
Now let’s introduce some stipulations into this scenario to better understand the effects of the ‘Grandfather Rule’. Let us say, the stock was bought prior to January 31, 2018. So this places a question mark on the ‘cost of acquisition’ which is calculated differently under the provisions of Section 112A.
We first look at the highest quoted price of the stock on 31 January 2018. Let’s say the stock touched a high of ₹12,000 during the trading day of 31 January 2018. You compare that with the selling price, which is ₹15,000 and select the lower of the two, which is ₹12,000.
Next, you compare that value with the cost at which you bought the stock, which is ₹10,000 and select the higher of the two. So the cost of acquisition would be ₹12,000 enhancing the buying cost by ₹2,000. The computation of the long term capital Gain by applying the universal formula would now be,
₹15,000 – ₹12,000 = ₹3,000
Thus reducing the value of the long term capital gains by ₹2,000 and ultimately reducing the long term capital gains tax liability to ₹300, down from ₹500.
The idea of these rules is to incentivize people enough to ensure that they continue to invest in the stock market, which in turn fund projects that build national wealth and GDP overall. Get in touch with our experts at Vakilsearch today to understand the true value of your long term and short-term investments in stock and to learn how to structure them in a way to maximize the returns on your investment.
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