In the second part of a series we discuss how to save tax on capital gains
Capital gains arising out of sale of shares, listed securities and units of UTI/MFs are blessed with a special concession. Resident investors have the option of choosing between tax at the rate of 10 per cent before indexation or at the rate of 20 per cent with indexation.
If an assessee has sold a number of shares and units on different dates earning a sizable amount of capital gains, he can choose to apply this option to each transaction separately.
Normally, he also suffers some capital losses, long-term as well as short-term, and also has some carried-forward losses to his credit. He sets off the losses against the gains in a haphazard manner and pays much more tax than what he need have paid.
This option of 10 per cent or 20 per cent can be used to devise a strategy that drastically reduces the tax payable on the net long-term capital gains.
All that needs to be done is:
* Set off short-term gains against short-term losses of the current year.
* If the result is excess short-term gain that cannot be set off, add it to the rest of the income of the year. Pay tax at normal rates after claiming various deductions and rebates.
* If on the other hand, there is an excess short-term loss that cannot be set off against short-term gains of the current year, add it to the carried forward loss from earlier years. Add also the long-term loss of the current year to arrive at the total loss.
* Compute indexed capital gains as well as profit (capital gain without indexation).
* Calculate 20 per cent tax with indexation and 10 per cent without indexation on the long-term gains, item by item. And choose the lower of the two as tax payable.
* Compute the ratio of this lower amount and the corresponding capital gains arrived at after indexation. Sort the sales in the order of highest ratio first (in descending order).
* Set off indexed capital gain of the item with the highest ratio against the total loss. Set off the balance loss against the item with the next highest ratio amongst the remaining items.
Continue the process until the entire loss is set off. The last chosen item may have to be split up into two parts. The first part will bring the carried forward loss to nil level.
* Tax is to be paid on the second part of the split item and also the remaining items.
Instead of setting of the losses in chronological order or any haphazard manner, this method will ensure that the assessee pays minimum tax.
To illustrate, we shall take the case of an assessee who had capital gains of Rs 50 lakh arising out of the sale of shares and set it off against his total losses of Rs 22 lakh.
Now, have a look at Table-1.
The first item chosen for the set off is the sale of equities of Company-G because the ratio of tax (10 per cent or 20 per cent, whichever is lower) and capital gain computed with indexation. This sets off only Rs 1.20 lakh out of the Rs 22 lakh which can be set off.
Then we take the next item, Company-H and continue with the set-off until we come to the Company-D. Here we find that the sale of only 30.41 shares (excuse the fraction) satisfies the required set-off of Rs 22 lakh.
On the remaining lot, he has to pay tax at the rate of 10 per cent or at the rate of 20 per cent, whichever is lower. The total works out at Rs 289,471. This is the least tax possible. Any other set off will result in a higher tax liability.
Purchase of a residential house
Now, we shall devise a new strategy dealing with Section 54F which gives exemption from tax on long-term capital gains if the assessee purchases or constructs a residential house within the stipulated time frame.
The exemption is 100 per cent where the cost of the new house is more than or equal to the net sale proceeds of the financial asset; in this case, the shares. Here, the investment has to be set off against the sales proceeds (and not against the capital gains).
To illustrate, we take the same example as above but assume that a residential house worth Rs 22 lakh has been bought and the assessee has no losses, suffered either during the current fiscal or carried forward. Here the objective changes. The focus shifts from capital gains to sales proceeds.
For instance, suppose there are two different shares that the assessee holds, X and Y. He has sold both the scrips for Rs 1 lakh but X entails a tax (the lower of 10 per cent or 20 per cent) of Rs 1,000 and similarly Y entails a tax of Rs 20,000.
If the assessee claims exemption for X he saves Rs 1,000 whereas in the case of Y he saves Rs 20,000. Therefore, we have to take the ratio of tax and sale proceeds for all the items and choose the item with highest ratio first and next highest second and so on.
It is found that in the case of set off of a loss of Rs 22 lakh (and no purchase of a house) the minimum-tax strategy depends upon the ratio of tax to the capital gains.
The tax payable works out to Rs 2,89,471. In the case of set off of re-investment in a housing property, the minimum-tax strategy depends upon the ratio of tax to sales and the tax payable is Rs 3,88,827.
What if the assessee can claim set off of the loss as well as the exemption for purchase of housing property and the total of the two is more than the gains?
In this case our objective function changes from minimising tax to maximising the carry forward loss. Therefore, we require a ratio, different from the two outlined above. Which one?
I invite suggestions from readers. However, do note that there is no prize for the correct answer. There
