When you sell an asset like a stock or mutual fund after a year - in some cases, like Gold, three years - you need to pay long term capital gains tax. Equity mutual funds where more than 65% of the holding is equity don't have long term cap gains tax currently, and neither does stock held for over a year - in both cases, you will pay a Securities Transaction Tax on the sale.
There are two ways to calculate long term capital gains tax.
The government understands that you might buy a product this year, but sell it after a few years. But in the process, inflation has destroyed the value of your money - i.e. what might cost Rs. 100 today might cost Rs. 130 in five years (assuming 5.4% inflation - remember, inflation is compounded). So if you sell the product after five years for Rs. 150, your gain really is Rs. 20.
To calculate this actual gain, the Income Tax department releases a cost-inflation-index (CII) figure every year. Usually, in May, it will release the CII for the last financial year - so the CII for 2010-11 will be released in May 2011. And it's not easy to find; but luckily enough people get to know and Google becomes a good friend.
Effectively, the cost of acquisition becomes substantially lower. The formula is:
Indexed Cost of Acquisition = (Actual cost of purchase) * (CII Of Year of Sale)/(CII of Year of Purchase).
Capital Gain = (Sale Price MINUS Indexed Cost of Acquisition).
Capital Gains Tax = 20% of Capital Gain
For example, if you bought 1000 units of a debt fund at Rs. 50 per unit in 2008-09 and sold the 1000 units in 2009-10 for Rs. 55, then:
(Purchase Price = Rs. 50,000 and Sale price = 55x1000 = Rs. 55,000)
a) Indexed Cost of Acquisition = 50,000 x (632/582) = 54,295.
b) Capital gain = 55,000-54,295 = 705.
c) Capital Gains tax = 20% of 705 = Rs. 141.
The indexation benefit allows you to let inflation take its toll on the purchase price; there is no such allowance for "short term" capital gains, in a mutual fund or stock sold within a year of purchase. In that case, the gain (non-indexed) is simply added to your income and your income is taxed appropriately, and that effectively means short term capital gains are taxed at the highest slab that applies to you.
The indexation benefit also substantially increases your post-tax return when you use a mutual fund rather than, say, a fixed deposit. The mutual fund is indexed for inflation, but the FD return is not (even the annual interest for a multi year deposit is added to your gross income and taxed).
To make life a little simpler, there is an allowance to ditch the entire indexation concept, where you have sold a mutual fund (or a stock outside the stock exchanges, say in a buyback offer). The idea is: your non-indexed capital gain = Sale Price MINUS purchase price. On that you pay just 10%.
You can choose with indexation or without indexation for every asset sale for the total capital gain that you have. In some cases it may be better to pay just 10%. For instance if you bought a stock 10 years ago, chances are it has multiplied so much that any amount of indexation doesn't cut much into your profits; you are then better off paying 10% of the unindexed gain rather than 20% of indexed gains.
Note: Reader Px noted that the IT department may not allow part of such debt mutual fund gains to be indexed and part not to be. This means you have to calculate your total gains with such indexation, and then without such indexation. Then see if the taxes are different on the two. That makes sense, but is complicated in the sense that you don't get the best benefit on your assets if you sell a lot of them. But I admit - this looks like something the IT department will allow more than my earlier assumption (i.e. choose indexation or not for each asset sale). I have changed the post - my apologies.
Example: Different purchase dates and FIFO
Now I will complicate matters. If you have bought :
* 1000 units at Rs. 10 on 1 Jan 2008,
* 1000 more units at Rs. 15 on 1 May 2008
* 1000 more units at Rs. 16 on 1 December 2008
* 2500 units at Rs. 17 on 30 December 2009,
How are the gains calculated?
Answer: Each purchase/sale transaction is matched on a First-In-First-Out basis. This is like a queue - the first person who is in the queue gets serviced first and get out, then the next and so on. Versus a "LIFO" or Last-In-First-Out, like in a crowded lift or a metro train where the last person in usually ends up getting pushed out before others can leave. The IT department needs FIFO.
All the units sold have been held for over one year, so long term capital gains tax applies.
So here, out of the 2,500 units sold, we have three separate pieces to be considered.
The First 1000 are matched to the first 1,000 bought, appropriately indexed, gains calculated and tax calculated.
- Here you get two years of Indexation (2007-08 and 2008-09) because the purchase to sell dates span two financial years - Jan 08 to December 09.
- Indexed Purchase Price = 10,000 * (632/551) = 11,470.
- Capital Gain = 17,000 - 11,470 = 5,530
The non-indexed gain is Rs. (17,000-10,000) = Rs. 7,000.
Indexed Capital Gain: Rs. 5,530
Non Indexed Capital Gain: Rs. 7,000
The Next 1000 units get one year's indexation because they are off by just one financial year (Jun 2008 to Dec 2009) These were purchased for Rs. 15,000.
- Indexed Purchase Price = 15,000 * (632/582) = 16,289
- Capital Gain = 17,000 - 16,289 = 711
Without indexation: The Capital Gain is Rs. 2,000 (17,000 minus 15,000)
Indexed Capital Gain: Rs. 711
Non Indexed Capital Gain: Rs. 2,000
The next 500 units are sold at Rs. 17 and bought at Rs. 16, which are again provided one year's indexation.
- Indexed Purchase Price = 16 * 500 * (632/582) = 8,687
- Capital Gain = 17 * 500 - 8,687= (Loss of Rs. 187).
The unindexed gain is (Rs. 17-16) * 500 units = Rs. 500.
Indexed Capital Gain: Loss of Rs. 187
Non Indexed Capital Gain: Rs. 500
So let's add them all up.
|Total Capital Gain||6054||9500|
|Capital Gains Tax Applicable (%)||20%||10%|
|Capital Gains Tax||1210.8||950|
You can choose which one of the two you want, and in this case the non-indexed option is better - you pay lower taxes.
Note: Long term capital gains must be all added up but in case of other assets (like houses or gold or such) you don't get to choose between 10% unindexed and 20% indexed. There it's only indexed (and long term applies only after three years). So if you have sold a house and some mutual funds, the calculation will take on the indexation or non-indexation benefit only for the mutual fund bits.
Nowadays most software do this for you, and brokerages provide detailed statements as well. (See MProfit, for instance. Disclosure: I'm not associated but a good friend works with them)
Gains are based on the number of units sold, and each unit's purchase price. What is left in the kitty in the above example is 500 units bought at Rs. 16. That will not attract any tax until you sell. The investor may buy more before selling, adding to calculation complexity.
I hope this helps clarify a subject I get a lot of email for. Please send in your comments!
Note: I'm not a CA - this is my understanding of the tax law. Apologies upfront for any mistakes; please let me know and I will correct.
(While the tax rates change with the Direct Tax Code (DTC), calculation methodology will remain the same, though non-indexation benefits might vanish)