The BCAS Column
September 30, 02
Time your losses to make the most of the restricted benefits of the new rules on set-offs.
The logic of asking one to pay tax in the face of losses is strange and best understood by the mandarins of North Block.
Ridiculous though it may sound under normal circumstances, a 'loss' is actually an asset under the Income Tax Act. This is to any transaction, can substantially reduce one’s incidence of Income Tax. First, by setting off the loss against the income earned in the year. And second, if not set off fully in the current year, by carrying it forward to be set off against income in subsequent years.
Understandably, one needs careful planning to ensure the right set-off of losses in the context of capital gains. But before we get into that, a little primer on capital gains tax, which is primarily a tax on inflation. It is a tax on deemed income, and not real income. For the purpose of taxation, capital gains are classified as short-term and long-term capital gains.
Short-term and long-term assets.
The classification is made on the basis of the duration for which a taxpayer holds an asset before transferring it. It so follows that the gains on the transfer of a short-term asset are classified as short-term gains. While any other gains are long-term capital gains.
Generally, a short term capital asset is one that has been held by a taxpayer for less than 36 months. However, in the case of shares of a company, debentures, warrants, bonds or any other securities listed on the stock exchanges, units of the Unit Trust of India (UTI) and mutual funds, the holding period is 12 months.
A long-term capital asset is one that is held for more than 36 months: or more than 12 months in the case of shares of a company, debentures, warrants, bonds or any other securities listed on the stock exchanges, units of the UTI and mutual funds. Illustratively a house that has been held for more than 36 months is a long-term capital asset: shares and securities that have been held for 12 months or more are long-term capital assets.
Rates of tax.
The distinction between the short term and the long term is important. Short-term capital gains are taxed at the normal rates; long-term capital gains enjoy substantial concessions. For one, long-term capital gains get the benefit of indexation. Two, they are taxed at a concessional rate – 10 per cent without indexation or 20 per cent with indexation at the option of the taxpayer. Again, it is exempt from tax if, subject to certain conditions, the gains or sales proceeds are invested in notified assets. This is precisely why it’s better to plan your gains such that you end up with a long-term capital gain.
The story so far…
Up until assessment year 02-03 (Financial year 01-02), no short term or long term distinctions were made for the purpose of setting off capital losses in the same year in which it was incurred. So, if a taxpayer made capital gains in respect of one transaction and a capital loss in respect of another, he was entitled to set off one against the other.
Such set-offs were allowed irrespective of the class of the capital gain or the kind of the asset transferred. And so, a short-term capital loss arising on the transfer of shares could be set off against long-term capital gains on the sale of residential house property in the same year. Again, if the loss could not be set off in the same year, it could be carried forward to the next year where it could be set off against long-term or short-term capital gains in that year.
What Finance Act 2002 changed.
Finance Act 2002 then came along and changed the scenario drastically. A long-term capital loss can now be set off only against long-term capital gains even in the year of the loss. It cannot be set off against short-term capital gains or any other regular income. Further, when carried forward to the next year, the long-term loss can only be set off against long-term capital gains.
The liberty to set off long-term capital losses against short-term capital gains in the same or in subsequent years has thus been withdrawn, saddling the taxpayer with the liability to pay tax on short-term capital gains even where he has sizable long-term capital losses. The logic of asking a person to pay tax in the face of losses is strange and best understood by the mandarins of North Block.
Lack of Logic.
Clearly, the move is a patent disincentive to hold and asset for the long term. The gravity of the amendment can be best understood by an example. Take for instance a case where a taxpayer sells 5,000 shares which have been acquired on different dates at varying costs over a period of two years. Let’s say the sale results in an overall gain of Rs. 5 Lakh: while the sale of some shares (bought within the last 12 months) resulted in a gain of Rs. 20 lakhs, the sale of others threw up a loss of Rs. 15 lakh. While computing capital gains, therefore, the taxpayer would have long-term capital losses of Rs. 15 lakh and short-term capital gains of Rs. 20 lakh. In such a case, the losses will not be allowed to be set-off against the gains, and the person will have to pay tax on short-term capital gains even where the losses are more than the gains. The resulting tax liability could be more than even the net gain of Rs. 5 lakh. The sale of bonus shares too high-lights the absurdity of the amendment as we shall see later in this article.
The amendment also has a side effect, which is, in a sense, retrospective. Long-term capital losses incurred in earlier years, which hitherto could be set off freely against short-term capital gains, can now be set off only against long-term capital gains. The situation in the case of short-term capital losses, however, remains unchanged. Such a loss continues to be eligible for a set-off against long-term capital gains in the year of the loss; it also continues to be eligible to be carried forward for a set-off against short-term or long-term capital gains in subsequent years. The losses can be carried for a maximum of eight years before they lapse.
Time your losses
The amendment means that one has to plan one’s income such that a transaction does not result in long-term capital losses. And if it does, you should try and set it off during the same year by booking corresponding long-term capital gains in the same year. Due to the general state of the stock market, it is likely that you may not run up actual gains, or if you do, it may be notional due to indexation of costs. In such a case, you could keep accumulating long-term capital losses without there being any possibility of a set-off, and such losses could ultimately lapse.
Such a situation may arise particularly in the case of mutual funds with a dividend option, where there isn’t much of an increase in the net asset value (NAV). If the mutual fund units are redeemed after a period of one year, it will surely result in long-term capital losses. Here, it will be better to redeem them before a year, subject, of course, to other considerations.
A similar problem may arise when you sell shares along with bonus shares, immediately after the issue of the bonus shares. In such a case, you could incur a long-term capital loss on the shares that are not bonus shares. This is because the ex-bonus price is generally lower. At the same time, you will run up substantial short-term capital gains on the sale of bonus shares, as the cost of bonus shares is taken as ‘nil’. Resultantly, you will not be able to set off your long-term capital losses against the short-term capital gains on the sale of bonus shares, and will have to pay full tax on the sales consideration of the bonus shares. Few cases could be more devoid of the logic than this one.
Clearly, the importance of carefully planning your transactions to make the most of a capital loss cannot be overstated. Importantly, to claim a carry forward of losses, it is necessary for you to file your return before the deadline. You will not be allowed to carry forward your losses if you do not file your returns on time. In the case of a person who is subject to a tax audit or any other audit or of a partner drawing remuneration from a firm is subject to a tax audit, the deadline is October 31. In all other cases, it is July 31. Don’t miss theses deadlines if you want to gain from a loss!
The author is a member of the Bombay Chartered Accountants’ Society bcasonline.org