Government`s U-Turn on Indexation: Navigating the New Indexation Landscape

Introduction:

The taxation of capital assets in India has long been influenced by various factors, including the tenure of ownership and inflation adjustments. One crucial aspect of capital asset taxation, especially in terms of long-term capital gains (LTCG), is the benefit of indexation. Indexation allows for the adjustment of the purchase price of an asset based on inflation indices, reducing the tax burden on long-term capital gains. However, the rules surrounding indexation have been complex and varied depending on asset types, ownership categories, and recent legislative changes.

Indexation and Its Impact on Taxation:

Indexation is a method that adjusts the cost of acquisition of a capital asset by considering inflation during the holding period. It uses the Cost Inflation Index (CII), a government-prescribed metric updated annually to reflect inflation levels in India. The formula for computing LTCG with indexation is:

Indexation ensures that taxpayers are taxed on the real gain (adjusted for inflation) rather than the nominal gain. For instance, if a property was bought for Rs. 10 lakhs in 2010 and sold for Rs. 25 lakhs in 2024, indexation would allow the purchase price to be adjusted to reflect inflation, lowering the taxable gain. Without indexation, the entire Rs. 15 lakh gain would be taxable, but with indexation, the tax liability would be considerably reduced as the adjusted purchase cost would be higher.

Recent Legislative Changes in Indexation Rules:

Prior to July 23, 2024, the benefit of indexation was available to all assessees, allowing them to adjust the purchase price of long-term capital assets, such as real estate, land, and securities, to account for inflation. However, this benefit was initially withdrawn through proposals made in the Finance (No. 2) Bill, 2024. Ultimately, when the Finance (No. 2) Act, 2024, was passed, it included certain changes that restored the option for indexation benefits to specific assessees who had acquired assets before July 23, 2024. These assessees could choose between paying a flat tax rate of 12.5% without indexation or 20% with indexation, allowing them to select the option that minimized their tax liabilities.

This change is beneficial for Resident Individual taxpayers and HUFs, allowing them to leverage the lower tax rate and maximize their post-tax returns. However, this benefit excludes entities such as firms, LLPs, and non-resident entities, who are still subject to different capital gains taxation rules without the same indexation relief.

Explanation of the Relevant Tax Provisions

The option for certain taxpayers to choose between paying tax at the rate of 20% with indexation or 12.5% without indexation arises from the combined reading of Section 48 and Section 112 of the Income Tax Act, 1961, as amended by the Finance (No. 2) Act, 2024. It`s important to note that this option is specifically available only for resident individuals and Hindu Undivided Families (HUFs) and applies exclusively to long-term capital gains arising from the transfer of land, buildings, or both.

Section 48: Limitation on Indexation Post-July 23, 2024

Section 48 deals with the mode of computation of capital gains and includes provisions on how the "cost of acquisition" and "cost of any improvement" should be calculated. The second proviso to this section clearly states that the benefit of indexation, which allows the taxpayer to adjust the purchase price for inflation, shall only be available for transfers occurring before July 23, 2024. After this date, the provisions of indexation will no longer apply.

Relevant Extract from Section 48:

"Provided further that where long-term capital gain arises from the transfer (which takes place before the 23rd day of July, 2024) of a long-term capital asset, other than capital gain arising to a non-resident from the transfer of shares in, or debentures of, an Indian company referred to in the first proviso, the provisions of clause (ii) shall have effect as if for the words `cost of acquisition` and `cost of any improvement`, the words `indexed cost of acquisition` and `indexed cost of any improvement` had respectively been substituted."

This means that post-July 23, 2024, the benefit of indexation contained under Section 48, is not available for any transfer, barring certain exceptions as provided under other sections of the Act.

Section 112: Tax Computation for Resident Individuals and HUFs

Section 112 outlines the tax rate applicable to long-term capital gains.

Relevant Extract from Section 112:

“112(1)(a) in the case of an individual or a Hindu undivided family, being a resident,—

(i) the amount of income-tax payable on the total income as reduced by the amount of such long-term capital gains, had the total income as so reduced been his total income; and

(ii) the amount of income-tax calculated on such long-term capital gains,—

(A) at the rate of twenty per cent. for any transfer which takes place before the 23rd day of July, 2024; and

(B) at the rate of twelve and one-half per cent. for any transfer which takes place on or after the 23rd day of July, 2024:

Provided further that in the case of transfer of a long-term capital asset, being land or building or both, which is acquired before the 23rd day of July, 2024, where the income-tax computed under item (B) exceeds the income-tax computed in accordance with the provisions of this Act, as they stood immediately before their amendment by the Finance (No. 2) Act, 2024, such excess shall be ignored;"

Combined Reading of Sections 48 and 112:

The second proviso of Section 48 unconditionally states that the benefit of indexation is only available for transfers occurring before July 23, 2024. After this date, the indexation benefit is generally not allowed.

However, Section 112 introduces an exception for resident individuals and HUFs who acquired land, buildings, or both before July 23, 2024. Specifically, it provides that if these taxpayers choose the 12.5% tax rate and the resulting tax exceeds what would have been payable under the 20% rate with indexation, the excess tax will be waived. This effectively reintroduces the benefit of indexation for these specific taxpayers, despite the general rule in Section 48 that eliminates indexation post-July 23, 2024.

Practical Implication:

This combined reading means that while the general rule post-July 23, 2024, eliminates the option for indexation, resident individuals and HUFs who acquired land, buildings, or both before this date still have the opportunity to benefit from indexation under specific conditions. If applying the 12.5% rate without indexation results in a higher tax liability than applying the 20% rate with indexation, they are effectively allowed to choose the option that minimizes their tax liability, ensuring a fairer outcome.

Table summarizing the benefit of option is reproduced as under-

Benefits of Indexation:

1. Reduction in Taxable Gains: Indexation allows for a significant reduction in the taxable capital gains by adjusting the cost of acquisition and improvement based on the cost inflation index. This results in a more accurate representation of the real economic gain rather than the nominal increase in asset value.

2. Higher Post-Tax Returns: Taxpayers who use indexation typically enjoy higher post-tax returns, as their tax liability is based on a smaller capital gain after inflation adjustments. This benefit is especially crucial for high-value assets like real estate and securities held over long periods.

3. Encouragement for Long-Term Investment: The availability of indexation promotes long-term investments in capital assets by mitigating the effects of inflation. Taxpayers are incentivized to hold assets for the long term, ensuring they benefit from both capital appreciation and lower taxes due to indexation.

Challenges and Considerations:

1. Complexity in Calculations: While indexation offers tax savings, the process of calculating indexed costs can be complex. Taxpayers must track the year of purchase and sale, refer to the correct CII values for those years, and accurately compute the indexed cost. Errors in these calculations can lead to incorrect tax filings and potential penalties.

2. Exclusion of Certain Entities: The recent restoration of indexation benefits is limited to individual taxpayers and HUFs, leaving out firms, non-resident entities, and certain other categories. This creates a disparity in tax treatment among different taxpayer categories.

3. Changing Legislation: The frequent changes in tax laws and indexation rules make it challenging for taxpayers to stay updated and compliant. The restoration of indexation benefits in 2024, for instance, followed a period of uncertainty, and future legislative changes could further alter the tax landscape.

Lets understand this with the help of examples-

Scenario 1: Beneficial Use of the 12.5% Tax Rate Without Indexation

Example:

- Purchase Date: April 2012

- Purchase Price: Rs. 50 lakh

- Sale Date: August 2024

- Sale Price: Rs. 2 crore

Cost Inflation Index (CII):

- CII for 2012: 200

- CII for 2024: 363

Indexed Cost Calculation:

Indexed Cost = Purchase Price × (CII of Sale Year / CII of Purchase Year)

= Rs. 50,00,000 × (363 / 200) = Rs. 90,75,000

Capital Gain with Indexation:

Capital Gain = Sale Price - Indexed Cost

= Rs. 2,00,00,000 - Rs. 90,75,000 = Rs. 1,09,25,000

Capital Gains Tax with Indexation (20%):

Tax = Rs. 1,09,25,000 × 20% = Rs. 21,85,000

Capital Gain without Indexation:

Capital Gain = Sale Price - Purchase Price

= Rs. 2,00,00,000 - Rs. 50,00,000 = Rs. 1,50,00,000

Capital Gains Tax without Indexation (12.5%):

Tax = Rs. 1,50,00,000 × 12.5% = Rs. 18,75,000

Conclusion:

The tax liability without indexation is Rs. 18,75,000, which is lower than the tax with indexation at Rs. 21,85,000. Hence, the 12.5% tax rate without indexation is more beneficial in this scenario.

Scenario 2: Beneficial Use of the 20% Tax Rate With Indexation

Example:

- Purchase Date: April 2005

- Purchase Price: Rs. 30 lakh

- Sale Date: August 2024

- Sale Price: Rs. 1.5 crore

Cost Inflation Index (CII):

- CII for 2005: 117

- CII for 2024: 363

Indexed Cost Calculation:

Indexed Cost = Purchase Price × (CII of Sale Year / CII of Purchase Year)

= Rs. 30,00,000 × (363 / 117) = Rs. 93,10,256.41

Capital Gain with Indexation:

Capital Gain = Sale Price - Indexed Cost

= Rs. 1,50,00,000 - Rs. 93,10,256.41 = Rs. 56,89,743.59

Capital Gains Tax with Indexation (20%):

Tax = Rs. 56,89,743.59 × 20% = Rs. 11,37,948.72

Capital Gain without Indexation:

Capital Gain = Sale Price - Purchase Price

= Rs. 1,50,00,000 - Rs. 30,00,000 = Rs. 1,20,00,000

Capital Gains Tax without Indexation (12.5%):

Tax = Rs. 1,20,00,000 × 12.5% = Rs. 15,00,000

Conclusion:

The tax liability with indexation is Rs. 11,37,948.72, which is lower than the tax without indexation at Rs. 15,00,000. Hence, the 20% tax rate with indexation is more beneficial in this scenario.

Thumb Rule for Decision-Making:

• Short Holding Period (Less than 10-15 years):

• The 12.5% tax without indexation is usually more beneficial, as inflation adjustments may not significantly reduce capital gains over shorter periods.

• Long Holding Period (More than 15 years):

• The 20% tax with indexation tends to be better due to significant inflation adjustments over time, which can substantially reduce the taxable capital gain.

Note: This is a broad conclusion and should not be used as an absolute indicator. The most beneficial tax option can vary depending on several factors, such as:

1. Rate of Inflation:

• High inflation over a long period can make the indexation benefit more attractive, reducing the effective tax liability significantly.

2. Nature of the Asset:

• Certain assets might appreciate faster than inflation, making the non-indexed lower tax rate more advantageous even for longer holding periods.

3. Future Income, Tax Bracket, and Surcharge Application:

• If you anticipate moving into a higher tax bracket in the future, indexation may be more beneficial as it reduces the taxable gains, thus potentially lowering the overall tax burden. Additionally, opting for indexation could help in preventing the application of a surcharge or reducing the rate of surcharge, which is applicable on higher income brackets.

Conclusion:

The restoration of indexation benefits for long-term capital gains on certain capital assets represents a significant relief for individual taxpayers and HUFs, especially in the context of inflationary pressures. However, the complexity of the system and the exclusion of specific entities from these benefits highlight the ongoing challenges in India`s capital gains taxation framework.