IncomeTax

How To Calculate Long Term Capital Gains Tax

7 comments Written on January 25th, 2011 by
Categories: IncomeTax

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.

With Indexation

Year

CII

Inflation
1981-82 100
1982-83 109 9.00%
1983-84 116 6.42%
1984-85 125 7.76%
1985-86 133 6.40%
1986-87 140 5.26%
1987-88 150 7.14%
1988-89 161 7.33%
1989-90 172 6.83%
1990-91 182 5.81%
1991-92 199 9.34%
1992-93 223 12.06%
1993-94 244 9.42%
1994-95 259 6.15%
1995-96 281 8.49%
1996-97 305 8.54%
1997-98 331 8.52%
1998-99 351 6.04%
1999-2000 389 10.83%
2000-2001 406 4.37%
2001-2002 426 4.93%
2002-2003 447 4.93%
2003-2004 463 3.58%
2004-2005 480 3.67%
2005-2006 497 3.54%
2006-2007 519 4.43%
2007-2008 551 6.17%
2008-2009 582 5.63%
2009-2010 632 8.59%
2010-2011 711 12.50%
2011-2012 785 10.41%

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).

Without Indexation

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

and sold

* 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.

image

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.

Indexed Non-Indexed
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)

Posted in IncomeTax

India Direct Tax Code Bill Tabled in Lok Sabha

18 comments Written on August 30th, 2010 by
Categories: DirectTaxCode, IncomeTax

The Government introduced the Direct Tax Code Bill today. After some serious amount of searching, I found the bill online, after struggling with pages timing out, debugging communication messages and guessing IP addresses. (Read: It was darn easy in the end, but I had spent so much time I needed to make it look like it was a bloody difficult job).

What matters is not that I found it. What matters is what is in it.

First, this bill of the DTC applies from 1 April 2012, so heave a sigh of relief.

For salaried income: Deductions are Employment Tax, Travel allowance (currently Rs. 800 a month), actual reimbursements, employer’s contribution to pension [upto 10% of salary], retirement or provident fund [upto 12%].

Housing rent allowance is fully exempt, without the complex formula – now it is limited to the rent actually paid. Nice.

Property income: Only rent actually received is taxable. You get to deduct local taxed and 20% of the gross rent, plus all interest paid on a loan for that property. If you take on a loan before the property is ready, you get to amortize the interest paid before possession over the subsequent five years, equally.

Securities Transaction Tax stays. We will now pause for a minute to pray for the arbitrageurs that died after that sentence.

Capital Gains: First calculate the gain as selling price minus cost price minus all intermediate costs. For shares and equity mutual funds on which STT is paid and held over a year, ZERO. Rejoice.

Shares and MFs with less than one year of holding – 50% of the gain (or loss) is “ditched” and the rest added to income.

For debt MFs or shares transferred off-market or Gold ETFs or things like that: To qualify for LTCG (Long Term Capital Gains) you have to hold the asset for “one year from the end of the financial year in which the asset is acquired”. If you buy on April 1, 2012, you have to hold it till after March 31, 2013 – that’s two years at the extreme. Then, you get to index the costs to inflation. If you’ve bought the asset before 2000, then you must assume indexation from 2000, but you get the option – and I mean it’s your choice to do this if it works in your favour – of using the price on April 1, 2000. This is incredible, for me, because my family owns shares held for over 20 years.

Any other short term capital gains are simply added to income.

There will be a Capital Gains Deposit Scheme where you can dump the proceeds (not just the gains, the entire proceeds) of capital asset sales (long or short term) and not pay tax. You can buy a house or agricultural land to offset cap gains taxes, within a year after the sale or use the Cap Gains Deposit Scheme, to park money upto three years to invest in such a tax-offsetting asset. You get to do this for max two residential properties for a person.

Deductions: Everyone gets a Rs. 100,000 deduction for money put into “approved funds”. What we don’t know – are ELSS mutual funds “approved”? Are "ULIPs” approved? Most likely no to both. They do mention that approved funds are –

  • PF, retirement or gratuity funds
  • Pension funds
  • Any thing else specifically approved

An additional Rs. 50,000 is deductible under 3 heads – 50K is the limit for all of them added up.

  • Pure life Insurance – defined as any policy where the premium is less than 5% of the sum assured for ALL years of the policy,
  • Health insurance
  • Two children’s tuition fees (including pre-school fees). But no donations or “development fees”.

Housing: This gets interesting. First, no principal deduction. Second, interest is only deductible if the house is completed within three years of the loan commencement. (And the pre-completion interest is amortized forward over five equal yearly installments. You don’t get the deduction during the pre-completion phase) The interest deduction limit is Rs. 150,000.

Higher Education loan interest is deductible for seven years, but it’s gotta be from a bank or FI (not relatives) and for a course the govt. recognizes. (Sorry, IIPM. Perhaps even ISB will not qualify!)

Medical expenses get a 40K deduction if you actually spend the money on medical treatment. 60K for treatment of senior citizens. Oh, and if you get insurance, that much is not counted.

Tax slabs: Upto 200,000 a year, no tax.
Rs. 200,000 to 500,000: 10%
Rs. 500,000 to 10 lakhs: 20%
> 10 lakhs: 30%.

It’s progressive, and slabbed. For senior citizens (65+), the first slab is 250,000. For companies, the rate is 30%, and Minimum Alternate Tax is 20% (but you can claim it back within 15 years)

Dividends and Insurance income distribution from “Equity Oriented Insurance Schemes” (ULIPs) get taxed – at 5%. The 15% dividend distribution tax stays. That means to go through equity mutual funds you actually pay a lot – first companies pay 15% tax on dividends, then the mutual funds get a tax hit of another 5%.

Wealth tax: 1% of whatever’s above 1 crore rupees, every year. But not including the house you live in. This is just horrible, but amounts to just 1% more income tax, if you look at it. But if someone has money in illiquid assets like multiple houses, or equity, they’ll find the going tough. Think of the promoters of Indian companies!

With about 35 lakh crores under private sector ownership, that alone will give the government more than 30,000 cr. of wealth tax revenue.

But the section actually doesn’t count assets like shares and bonds! This needs lawyer input but it seems like for wealth, they consider land, farm houses, cars/yacht/aircraft, jewellery and bullion, antiques and paintings, expensive watches, cash, and shares held in foreign companies. Nothing about Indian company shares, or bonds, or mutual funds.

EEE or EET: NPS goes Exempt on withdrawal – commutation of pension (lumpsums) upto 1/3rd or 50% of the amount in different cases.

Life insurance paid on death is exempt. This is still a great way to transfer assets without a will.

All exemptions for donations to non-profits, political parties etc. stay.

Nothing much changes, really, other than a few exemptions gone, and wider tax slabs. Retaining LTCG at zero for equity markets is good, of course, but it won’t last that long. Wealth tax can be a huge issue or a non-issue, if there is clarity on whether it applies on share/bond holding.

To me this is no big deal – just business as usual. But the equity markets have reason to rejoice.

Posted in DirectTaxCode, IncomeTax

Direct Tax Code Bill Kinda-Sorta Happens

10 comments Written on August 26th, 2010 by
Categories: IncomeTax

The Union Cabinet has cleared the Direct Tax Code bill, which means nothing other than it will actually be cleared by December if it’s tabled on Monday, and that means sometime in the next decade it might actually happen.

The DTC simplifies tax slabs. Upto 2 lakhs, nothing, it seems. 2 to 5 lakhs, 10%, 5 to 10L, 20% and above 10L, 30%. Nothing earth shattering – the current limits are 1.6, 5 and 8 Lakhs.

Corporate tax goes to 30%. From 33%. That’s nice. MAT for those fellows not paying tax is 20% of book profits.

PF is exempt from tax, or so they say, but the rest get taxed EET. Dividend distribution tax stays the same. Life Insurance payments and  mutual fund income gets a 10% TDS. (10% of what? We don’t know).

I don’t know if STT is out. I don’t know what happens to various random exemptions. I don’t know I can’t really say until I see the full bill – everyone’s taking data from an interview of the Finance Minister, where it’s likely there weren’t enough questions asked or answered. Anyone have a copy?

Posted in IncomeTax

Designation of Assessing Officer or Ward/Circle

2 comments Written on July 27th, 2010 by
Categories: IncomeTax

When filling income tax forms, there’s an entry for the Designation of the Assessing Officer and Ward/Circle. This might be irrelevant for you, but if you do need to fill it up here’s how you can get the information.

Go to https://incometaxindiaefiling.gov.in/portal/index.jsp.

Click on Services | Know Jurisdiction.

image

Type in your PAN number.

image

And you get results like:

image 

Write everything you see here, into that field in the IT return form. For the above you would use
KAR/C/221/1/DCIT/ACIT CIR 8(1)

Hope that helps.

Posted in IncomeTax

On Yahoo: Death by Taxes

2 comments Written on June 9th, 2010 by
Categories: IncomeTax, Yahoo

My latest column at Yahoo is about how taxes muddle our investment decisions:

Nothing is certain but death and taxes, an old saying goes. The man who said those words went on to die, and no longer needs to worry about taxes. But you and I do -- and I sometimes feel that taxes are a more painful choice. Anyway, from an investor's point of view, taxes impact our returns and complicate our investment choices.

Consider for instance, the average bank Fixed Deposit (FD) at 7% a year. If you invest Rs 10 lakhs you will receive an income of Rs 70,000 a year. If your net income, including this interest, is greater than 5 lakhs, you'll end up paying 30.9% as taxes, reducing your income to Rs 48,370 - a post-tax return of just 4.84%. Read the rest of this entry »

Posted in IncomeTax, Yahoo

Direct Tax Code: Book Profits and Buy Back?

11 comments Written on March 3rd, 2010 by
Categories: DirectTaxCode, IncomeTax, Stocks, TaxSaving

With the Budget revealing that the Direct Tax Code will be implemented from April 2011, a few choices have to be made now. The DTC brings in capital gains tax back again – even long term capital gains, which don’t get “preferential” treatment as they have in the last few years. Long term capital gains – where the purchase is over a year ago – is currently NOT taxed, and earlier they were only taxed at 10% max.

From April 1 2011, all capital gains booked will be added to your income and taxed appropriately in your tax slabs. (Upto 1.6 lakhs – no tax, 1.6 to 10 lakhs – 10%, 10-25 lakhs – 20% and above that, 30%).

Then why is capital gains any different from other income? Answer: Long term gains are “indexed” – meaning, the government understands that when you sell an asset, you should consider inflation. If you bought something for Rs. 100 three years ago, and inflation was an average of 6% in the last three years, then the Rs. 100 is actually worth Rs. 118 today – three years of simple 6% inflation. (Note: the actual number will be slightly higher due to compounding effects). So if you were to sell that asset for Rs. 140 today, your gain isn’t Rs. 40 – it’s only Rs. 22; since you are only taxed on gains, it lowers your tax incidence by 50%!

For more details on indexing read: http://blog.investraction.com/2006/12/long-term-capital-gains-ltcg-applies.html.

The wider slabs, too, give you a lower tax payout. Yet, some of us have held stocks for a LONG time. Maybe 5 or more years. The gains are probably huge – some of them above 50%. If we sold them anytime after April 1, 2011, then we’d pay tax on the entire gain! This is of course unacceptable, given there is a cheaper way out.

You can sell all these shares today and buy them right back. Then, the gains will be assumed to be booked today – on which there is a capital gains tax of ZERO. That sorts the past gains. From here onwards, only the gains from the NEW purchase price to whenever-you-sell will count for taxation post April 1, 2011.

Example: In my family we own some shares of Hero Honda bought in the nineties. The effective cost price today, after all their bonuses, is about Rs. 12 per share. The share is at Rs. 1750+. Even if I indexed everything like crazy, my cost price won’t go beyond Rs. 100 per share – we have to pay taxes on about Rs. 1600 per share if we decide to sell after April 1, 2011!

The right thing to do then is to sell shares, get the money and buy them right back, because we want to be invested in Hero Honda. That takes care of the full gain till now – no tax on the 1600 rupees – and if Hero Honda goes to 2000 when we sell, we’ll only pay tax on Rs. 250.

And there’s another thing: if we sell now, before March 31, 2011 and buy shares back, we will get TWO years of indexation; indexing laws work such that each financial year of purchase is counted for indexing, which means a purchase tomorrow and a sale in April 2011 gives me two years of indexing – 2009-10 and 2010-11 – so I can get the advantage of two year’s inflation before my gains are counted.

To put it simply: If I sell now and buy back before March 31, I will save 12% of future gains as well. If Hero Honda went to 1960 and I sold it in April 2011, I will pay ZERO tax. Not bad at all, in a thirteen month scenario.

Another thing to think about: if you want to buy stocks for the long term, buy them before March 31. No matter when you sell them you get an additional year of inflation adjustment and saves you tax.

Downside notes:

  • Selling and buying back involves payment of commissions and STT. That, for me adds up to less than 1% of the entire transaction value  (not just the gains). Considering the huge gains we have, we are better off than the potential tax of 10% on the whole deal. But to you it may be huge if the gains are not quite as much.  For example if you own 100 shares of Reliance at Rs. 800 for two years and it’s at 1000 today; your indexed gain if you sell now is just Rs. 100 per share, assuming 6% inflation. If you’re in the 20% bracket next year that would only result in a tax of Rs. 2,000. But a 1.5% transaction cost on selling and buying back 100 shares (@ Rs. 1000) today will cost you Rs. 3000. So do the calculations carefully before logging on to your broker’s web site.
  • You need a two day break before you can buy again. The T+2 settlement system ensures that if you sell today you only get money after two working days. That means a “buy again” can only happen then. In the meantime the share could fluctuate in value, so there’s a risk.

The sell and buy back makes sense if you have very high gains and don’t want to pay tax on them.

Posted in DirectTaxCode, IncomeTax, Stocks, TaxSaving

Should you invest in Tax Saving Mutual Funds?

13 comments Written on January 15th, 2010 by
Categories: IncomeTax, MutualFunds, TaxSaving

If you buy a tax saving mutual fund – an ELSS scheme or something with “taxsaver” in it – you expect a tax deduction. But does it always apply for you?

ELSS mutual funds are specially deductible under Section 80C, which applies to everybody. It really means you get a Rs. 100,000 deduction from income (i.e. taxes are calculated after this deduction) – if you spend or invest this 100,000 in some specific areas:

  • Public or Employee Provident Fund contributions
  • the New Pension Scheme contributions
  • National Savings Certificates, 5 year Bank or PostOffice Deposits, NABARD Bonds
  • Insurance premium (Premium < 20% of sum assured)
  • Mutual Funds (ELSS)
  • School fees for two children (includes Pre-school fees, yay!)
  • Principal repayment on a housing loan (or full/down payment on a house)

They all come clubbed in the same 100,000 deduction – meaning if any combination of the above goes above 100,000 – then that’s all you get. First, find out if you’ve already exceeded the 100K deductible. If you have, don’t bother reading ahead.

Since you haven’t yet finished it all up, find out if you’re adequately insured. Hundred of insurance sites have them – for an IE only (no firefox) quick plan, check out this site. Then buy the plain term plan – Religare’s iTerm Plan, sold only online, is the cheapest by a LARGE margin. (I will pay Rs. 21K for a 25 year 1 crore policy, where the average other policy is 33K)

Do not buy ULIPs. They are evil.

If you still have anything left in that 100,000 tax deduction, you might think of ELSS mutual funds. Now you might be in for a surprise with the Direct Tax Code coming into force in 2011.

The DTC moves to an EET regime – Exempt on entry, Exempt on accumulation and Taxed at exit. ELSS is currently EEE – you save tax when you enter, and because of the STT benefit you pay no tax on exit. That will change – after 2011, any exit from an ELSS fund will be treated as “capital gains” and taxed in your tax bracket. If you buy an ELSS fund, the earliest you can exit is 2012-13, by which time the DTC will be active (and yes, it will apply to your old investments as well, unless they change the current draft)

The DTC even charges the withdrawal on the principal (not just the gain) – but it’s currently hazy about whether it will apply to past investments. Dhirendra Kumar at Value Research thinks that it will not apply to past investments and the draft code will be changed. Still, there’s a risk this works against you.

If you really need most of the money back in three years, buy a PPF/EPF instead – at least that has no tax on principal & interest till March 2011.

But the ELSS fund investment is a long term one and in all likelihood you can retain it for several years, only taking out what you might need. Even with tax, the gains from equity may be substantial, and high enough to outperform the PPF/EPF rates (the NPS has done 14 and 11% in the last two years; most ELSS schemes are just about where they were two years back)

With the higher mutual fund commissions too, their future returns are suspect. But I’d say this – it’s probably a better bet to go with a good tax saving fund and keep the money in there till you retire. It’s a good long term saving system with enough liquidity that you can take it out anytime after three years, but won’t because it’ll get taxed. And if you don’t need the money, then please use the NPS – the ultra low management fees juice up the returns substantially.

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Posted in IncomeTax, MutualFunds, TaxSaving

Play School Fees are Tax Deductible

No Comments » Written on January 15th, 2010 by
Categories: IncomeTax

Good news for parents of toddlers: The Latest Income Tax Circular, clarifies that Playschool fees qualify for tax deduction under section 80C, under the “full-time” education clause:

Full-time education includes any educational course offered by any
university, college, school or other educational institution to a
student who is enrolled full-time for the said course. It is also
clarified that full-time education includes play-school
activities, pre-nursery and nursery classes.

It may not sound like a huge deal to most of you but with the amounts these play schools charge nowadays, it’s some consolation to us parents.

Just a heads up. If you have such fees you probably are already at your 80C limits and don’t need to make more payments. If you’re an employee who is getting tortured by his accounts department to provide those 80C deduction receipts, hand them your child’s playschool receipts with a smug expression on your face and show them the above link.

Posted in IncomeTax

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