Indexation Benefits on Capital Gains — An Analysis

History

Originally, capital gains were made taxable vide insertion of Section 12-B¹ into the Income Tax Act, 1922. The present income tax legislation, viz. the Income Tax Act, 1961 (IT Act) taxes income of the nature of capital gains under Section 45. Initially, capital gains as per Section 48, was determined as the difference between the full value of consideration and the total cost of acquisition/improvement and expenses incurred in connection with the transfer. Vide the Finance Act, 1987, an amendment was carried out conferring a standard deduction at specified percentages in computing the income under the head “capital gains”.

Introduction of concept of indexation

In the year 1991, a Tax Reforms Committee, Ministry of Finance, Government of India (‘Government’), spearheaded by Dr Raja J. Chelliah, was constituted to examine the structure of direct and indirect taxes. The Committee, through a published interim report, recommended that the Government should factor indexation in computation of capital gains.

Taking due cognizance of the said recommendation, the then Finance Minister stated in the Budget Speech dated 29-02-1992 of Financial Year (FY) 1992-1993:

“The present tax treatment of long-term capital gains (LTCG) has been criticised on the grounds that the deduction allowed in computing taxable gain is not related to the period of time for which the asset has been held. It does not consider the inflation that may have occurred over time.”²

A second proviso was inserted into Section 48 to provide that while computing capital gains in respect of a long-term capital asset, an assessee will be permitted to reduce indexed cost of acquisition and indexed cost of improvement. The manner of computing the indexed costs was also stipulated and was linked to the notified cost inflation index(ices) (CII) of respective years in which the asset was acquired and transferred. The base year for CII was initially kept at 1-4-1981. However, vide the Finance Act, 2017, an amendment was made to Section 55(2)(b) of the IT Act and the said base year for CII shifted to 1-4-2001. Further, for the purposes of cost of acquisition, an assessee was permitted to adopt either the actual cost or the fair market value as on 1-4-2001, wherever the date of acquisition of the capital asset was prior to the said date.

Proposed amendment vide the Finance Bill, 2024 and subsequent amendment to the said Bill

Section 112 of the IT Act provides for taxation of LTCG. At present, the rate of tax on long-term capital gains is 20% and the capital gains is computed by considering the indexed cost of acquisition and indexed cost of improvement.

The Finance Bill, 2024 amended Section 112 to reduce the rate of taxation of long-term capital gains to 12.5%, while withdrawing the benefit of indexation for any transfers that took place after 23-6-2024.

However, this Amendment proposed by the Government met with a lot of hue and cry from all taxpayers and one significant criticism was that removal of indexation benefit can greatly affect the lower income and middle-class groups. Thus, the Government moved an amendment to Section 112 of the IT Act. Post the said Amendment, the second proviso to Section 112 has been inserted wherein it is provided that in case of transfer of land or building or both, which is acquired before 23-7-2024, where the income tax computed exceeds the income tax computed in accordance with the provisions of the IT Act, as they stood immediately before their amendment by the Finance Act, 2024, such excess shall be ignored. In essence, the second proviso provides that for long-term capital assets (being land or building) acquired before 23-7-2024, the assessee has been conferred with the following alternatives for computation of LTCG—

1. Compute the tax on LTCG at 20% after considering the benefit of indexation.

2. Compute the tax on LTCG at 12.5% without considering the benefit of indexation.

It is pertinent to note that the option of choosing between the said regimes is available only to individuals and Hindu Undivided Family (HUF). The same does not extend to other assessees i.e. domestic companies, firms, limited liability partnerships (LLP), etc. Further, the above choice between two alternatives is only available to transfer of land or building. It clearly does not cover other long-term capital assets like gold. The applicability of benefit to transfer of other capital assets like leasehold rights can be a potential subject-matter of dispute on whether such rights should be treated on par with land or building or otherwise.

Removal of the benefit of indexation — an effect of treatment in other countries

If one were to examine the tax treatment accorded by other countries, USA does not currently provide for a benefit of indexation. The United Kingdom originally conferred the said benefit, however, in 2008, the indexation benefit was altogether removed for individuals and the indexation benefit was paused from 2018 for corporates. Australia confers indexation benefit, and the tax laws provide for indexation as one of the methods for calculating capital gains. However, Australian tax laws permit indexation for inflation only up to 30-9-1999 i.e. the indexation factor shall be the consumer price index as on 30-9-1999.

The proposal to withdraw indexation benefits eventually could be an attempt towards tax simplification and aligning with certain global practices in general in calculating tax liabilities.

Parity with other sources of income

Indexation benefit under the law was conferred only to income under the head capital gains. The grant of such benefit ensured that accretion to investments made solely on account of inflation was not taxed and only the appreciation in value of the underlying asset was taxed. Such a benefit though may have been equally relevant, was not conferred to any other source of income. For instance, if a real estate dealer engaging in purchase and sale of immovable properties as a business, purchased a land parcel in 2009 and sold it in 2023, the net gain being the simple difference between the sale consideration and cost of acquisition would be taxed, while permitting such a person to claim for all expenses incurred in this connection. On the contrary, for an assessee holding such a land parcel as capital asset, gains would be computed factoring indexation. Thus, the legislature’s intent to ultimately sunset the indexation benefit for capital gains would lead to greater parity between the computation of income under different heads. However, a person carrying on business may still enjoy a better tax benefit stemming from the larger bucket of possible expense deductions available.

Conclusion

Indeed, when the Budget proposals originally contained a move to completely whitewash indexation benefit, it sent shock waves across the taxpayers considering that such a proposal notwithstanding the reduction in taxes could result in an increased tax outflow especially for the taxpayers belonging to lower and middle-income groups for whom the additional outflow could be a serious cause of concern. The subsequent amendment made to the Finance Bill to provide individuals and HUFs with an option to choose the method of computation has been welcome across the nation. If tax simplification is one of the objectives, then certainly, reducing rates and withdrawing multiple complications would ease the tax compliances and tax administration. However, it would be in the interest of both taxpayers and tax administrators alike that the legislature achieves its goal of tax simplification in a slow and seamless manner that equally takes into cognizance the pulse of the taxpayers and the impact on the exchequer.