Long and short of capital gains tax

How is capital gains tax applied to bonus, rights offers, open offers and buybacks?And what do you do with capital losses? Here’s a ready reckoner.

As the old adage goes, ‘Nothing is certain but death and taxes’. If stock market investing has caught your fancy, here too, you cannot avoid the taxman. Whether you are busy making money or burning your fingers out in the markets, take time off to comprehend how tax laws treat the gains and losses on your investments.

Taxing language



‘Long’ and ‘short’ in the taxman’s parlance have quite a different meaning than when used in the stock market context. To understand how the gains or losses we make on our stocks are taxed, we first need to get a grip on the distinction between long term and short term, in the tax context.

Shares are considered short-term assets if held for not more than twelve months. If the holding period exceeds twelve months, it is a long-term capital asset. Knowing this difference is important because the method of calculation of capital gains and the applicable tax rates vary under the two circumstances.

A capital gain is the excess of consideration received on transfer, over the cost of acquisition and incidental expenses. As a thumb rule, remember that for the assessment year 2009-10 (FY 2008-09), a short-term capital gain (STCG) from the transfer of shares is taxable at a flat rate of 15 per cent (excluding any surcharge/cess); long-term capital gain (LTCG) is exempt from tax. But this applies only when the transaction takes place through a recognised stock exchange and Securities Transaction Tax (STT) is paid.

Buybacks and open offers

What if the above conditions are not satisfied? This may happen in such circumstances as the sale of shares through off-market deals, buyback of shares by companies, and open offers or sale of shares of private companies.

Choppy market conditions, such as those that prevailed over the past year, have prompted many companies to announce buybacks. These companies may have bought back their shares held with you directly instead of routing it through the stock exchange. In that case, the tax treatment for LTCG and STCG varies.

Let’s say Anuj holds 1,000 shares of a company, which he bought at Rs 50 per share in June 2008. The company offers to buy back the shares directly at Rs 65 in November 2008 and he accepts the offer. In this case, the difference of Rs 15,000 ( 1000*65 – 1000*50) will be treated as STCG in the hands of Anuj. Since this transaction was not routed through the stock exchange and Anuj did not pay STT, the gain will be added to Anuj’s normal income under ‘other’ heads and taxed at his applicable slab rates.

Had Anuj bought these shares in June 2005 instead of June 2008, the holding period would have crossed 12 months by November 2008. Here, the LTCG , unlike in the previous case, is taxable. Income-tax law gives him an option in the method of calculation of gains.

He can choose to pay a tax of 20 per cent after indexation of his acquisition cost or pay a tax of 10 per cent without indexation, based on whichever is beneficial to him. With indexation, his cost would be 50,000 * 582/497 = Rs 58,551. (Cost of acquisition * Cost Inflation Index of the year of transfer / Cost Inflation Index of the year of purchase).

So, the gains would be Rs 65,000 – Rs 58,551 = Rs 6,449. Tax at 20 per cent will be Rs 1,290. Without indexation, the tax will be 10 per cent of Rs 15,000 = Rs 1,500. In this case, by opting for indexing his cost of acquisition, he saves on taxes.

When the acquirer of a company makes an open offer to you as a shareholder, you may be transferring your shares through an investment banker and may not pay STT. In that case too, you may have to shell out short term and long term capital gains tax at different rates than what would be applied to transactions made through the exchange.

Bonus, rights issues

Ashok holds 500 shares of a company, which he bought at Rs 20 per share. Let’s assume he receives a 1:1 bonus from the company. Ashok now holds 1,000 shares altogether. Theoretically, his total cost of acquisition of Rs 10,000 (500 *20) is now spread over 1,000 shares @ Rs 10 per share.

However, according to tax laws, the cost of acquisition for bonus shares (although theoretically Rs 10 per share) is to be taken as ‘nil’ for the bonus shares. Cost of acquisition of the original lot will be the price at which he bought the shares initially.

Hence, in the sale of bonus shares, the entire consideration received will be taxed as STCG or as LTCG, as per the rules already discussed. To figure out whether the capital gains are short-term or long-term, the date of the receipt of the bonus is considered.

When transferring shares acquired through a rights issue, the cost of acquisition will be the amount actually paid to obtain the right. The holding period will be calculated from the date of allotment of the rights shares.

First in, first out

Say, you bought 100 shares of Maruti at Rs 725 in June 2008. When the stock price fell further, you bought another 50 shares at Rs 500 at end October 2008. Today, you sell 30 shares at Rs 480. What will be your cost of acquisition? Rs 725 or Rs 500? Enter FIFO — the first in, first out principle. Accordingly, these 30 shares will be considered sold from the lot that first entered your account — 100 shares @ Rs 725 per share.

FIFO also ensures that you do not have a choice with respect to selling your bonus shares first. When holding shares in dematerialised form, you cannot ‘choose’ to sell the bonus shares before your original lot.

When a sale happens after a bonus issue, the price of shares sold will be matched with your originally held lot to calculate capital gains; only then will the bonus lot (with nil acquired cost) be taken into account.

Well, with the kind of turbulence that the markets have witnessed for nearly a year now, many of us are looking not at the prospect of a capital gain, but at that of a loss. So what are your options?

Capital loss

Tax laws allow you greater leeway on short term losses, than on long term losses. If you have incurred a short-term capital loss, it can be set off against any STCG or LTCG.

If there is no STCG or LTCG in the current year, you can carry forward the loss for a period of eight assessment years immediately succeeding the current assessment year (2009-10), during which you have incurred the loss.

A long-term capital loss can be set off only against a LTCG or carried forward (for eight years).

If you have incurred a long-term loss on shares which, had it been a gain, would have been exempt from tax, then, this loss has to be ignored and can neither be set off nor carried forward. Otherwise, it can be set off or carried forward and set off against any taxable LTCG.

Another point to be noted here is that if you propose to carry forward loss under the head “ capital gains”, then you must file your return of income showing the loss within the due date for filing the return (July 31 for individuals). If you don’t, you will forfeit your right to carry it forward.

Source: TheHinduBusinessLine