NAME: Soumya Swarup Mohanty

ID NUMBER: ADCTX02_21

SUBJECT NAME: Paper-III : Taxation of Incomes of Companies Part II

TOTAL NUMBER OF PAGES: 10 (including first page)

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 CAPITAL GAINS TAX IN INDIA: A DETAILED STUDY

INTRODUCTION

“Income tax is charged on the total income of a previous year at the rates prescribed for the
Assessment Year. Assessment Year means the period of 12 months commencing on April 1, every
year. Previous year is the financial year immediately preceding the assessment year. Income tax is
charged only on incomes received, accruing or arising in India or which are deemed to be received,
accrued or arisen in India.”1 Now, it needs to be understood that for the purpose of calculating and
imposing tax on total income, income is segregated into various heads depending on the source of
income. There are five heads of income and they are mutually exclusive of each other. This means
that when a certain income is said to fall under one head then it cannot be considered for calculation
under another head. “The various sources of income are classified in the following manner:

(1) Salaries
(2) Income from House Property
(3) Profits and Gains of Business or Profession
(4) Capital Gains
(5) Income from Other Sources.”
In this paper, ‘capital gains’ is the concept and source of income that is going to be dealt with. A few
concepts, such as capital gains, capital gains tax and capital assets need to be understood to get a
better grasp on the subject at hand.

In simple words, Capital gains tax is a type of tax that is imposed on the tax payer for any profit or
gain that the taxpayer receives by the means of selling a capital asset.

“Profits or gains arising from the transfer of a capital asset made in a previous year is taxable as
capital gains under the head of Capital Gains. The important ingredients for capital gains are,
therefore, existence of a capital asset, transfer of such capital asset and profits or gains that arise from
such transfer.”2

So, as can be seen from the above statement, certain conditions exist, that need to be fulfilled for a
person to be charged under the tax head ‘Capital Gain’. These conditions have been adequately
mentioned and stated in the case of Asstt. CIT v. Dr. B.V. Raju 3, the Income Tax Appellate Tribunal
held that “for attracting charge to tax under the head Capital Gain; the following conditions are
necessary to be fulfilled, viz:

(a) There must be a capital asset

(b) There should be a transfer of the capital asset other than an exempted transfer
1
How to Compute Your Capital Gains, Booklet, Income Tax Department of India (2015).
2
Ibid, 3.
3
Asst, CIT v. Dr. B.V. Raju [2012] 135 ITD 1 (Hyd.) (SB).

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(c) The capital asset should be something which can be acquired by paying a cost i.e. the cost of
acquisition of the capital asset should be determinable.
(d) There must be accrual of consideration for the transfer of capital asset.”

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 DISCUSSION / FINDINGS

ACCORDING TO CASE LAWS, WHAT TYPE OF ASSETS ARE TO BE CONSIDERED AS

AND INCLUDED AS CAPITAL ASSETS?

To understand which income can be taxed under the ‘capital gains’ head, we need to understand what
is meant by the term capital asset. Section 2(14) of the Indian Income Tax Act, 1962 has made an
effort to define the term capital asset. Section 2 clause 14 sub-clause (a) states: “property of any kind
held by an assessee, whether or not connected with his business or profession.” Section 45 of the
Income tax Act, 1961 states what is considered under the head capital asset to be taxed with capital
gains tax. Here, it should be noted that the term property has not been defined anywhere in the Income
Tax Act and the list of exclusions that exists in the Act was put in via an amendment to the original
Act.

The term ‘property’ has been defined by the Judiciary on more than one occasion and in a multitude
of cases. In the case of RC Cooper v. Union of India, the Supreme Court looked at all the previous
cases that defined the term property and while giving the term ‘property’ a wide import stated that
property is “to be a bundle of rights which the owner has over or in respect of a thing, tangible or
intangible, or the word ‘property’ may mean the thing itself over or in respect of which the owner may
exercise those rights.”4

Now, looking at the term ‘property’ in the context of capital gains and taxation of capital gains, it
basically means something that has the ability to be transferred. The Income Tax Act, 1961 basically
defines capital asset is a positive and negative way. This means that it first gives an all inclusive
definition stating that property of any kind held by the assesse and then goes on to list the items
specifically included and specifically excluded from this term in context of taxation. However, there
are a lot of things about which nothing has been said in the Act. Over the years, through various case
laws, the judiciary has given us more clarity as to what can be considered as property under the head
of ‘capital asset’.

Let’s have a look at the things which can be considered as property under the head capital asset which
have not been expressly included in its definition under section 2 clause 14 of the Income Tax Act,
1961.

 IS GOODWILL INCLUDED IN PROPERTY FROM THE ASPECT OF CAPITAL

GAINS?

4
RC Cooper v. Union of India, (1970) 1 SCC 248

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 Goodwill is an intangible asset. Goodwill is also considered as a capital asset. By this logic, it
will also be subject to the capital gains tax. The case in point here is that of CIT v. B.C.
Srinivasa Setty5. This case dealt with the question as to under what circumstances, goodwill
can be considered as a capital asset. For the purpose of this, the Court first tried to define the
concept of goodwill and while doing so emphasized on the fact that “although goodwill was
easy to describe, it was nonetheless difficult to define.” This case stated that goodwill is a
capital asset and is subject to tax under the capital gains head. The case referred to the
conflicting opinions that were held and stated that goodwill being considered as a capital asset
is the favoured view. Further, goodwill of a new business or transfer of goodwill of a newly
commenced business is not a capital asset under the meaning of Section 45 of the Income Tax
Act, 1961.

 IS A STOCK OF SPARES CONSIDERED AS PROPERTY FOR THE PURPOSE OF

CAPITAL GAINS?

A stock of spares are to be treated as a capital asset. This is because they are not required
immediately to work and can be used in the future. An important case for this is the case of
CIT v. Kasturi & Sons Ltd. 6, where the Madras High Court held that spare parts are to be
treated as capital assets. In this case, what had happened was that the company had stocked up
spare parts of an aircraft for future use if necessary. The aircraft was sold and later, after the
sale of the aircraft, these spare parts were also sold off. The assesse sold the spare parts at a
lower than book value rate and claimed deduction on the ground of revenue loss. This claim
was rejected by the Revenue and they stated that this was to be considered as a capital loss.
The court reasoned that, “The Tribunal itself found that it is not a trading asset and that the
spare have been purchased for use in the aircraft if occasion or necessity arises. Such a stock
of spares which is not immediately required to work or exploit the capital asset and which
could be used only in the future can only be treated as a capital asset.”

 ARE INTANGIBLE ASSETS CONSIDERED CAPITAL ASSETS?

Certain intangible assets are considered to be capital assets. The intangible assets such as
goodwill, trademarks or brand names, patents, etc are considered to be capital assets. Whether
there was a cost that was incurred in the acquisition of such assets is not important and such

5
CIT v. B.C. Srinivasa Setty, (1981) 2 SCC 460
6
CIT v. Kasturi & Sons Ltd., (1985) 152 ITR 748.

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 acquisition costs would be considered to be nil. These are assets which have capital value and
can be sold or transferred as well. When such assets are transferred for an amount of money,
such gain would amount to capital gain. In the case of Albright & Wilson Ltd. v. ITO, it was
held by the Bombay Tribunal that know-how when patented would be considered a capital
asset.

 IS THE RIGHT TO SUE FOR DAMAGES CONSIDERED A CAPITAL ASSET?

The right to sue for damages is not something that can be assigned and transferred. The
transfer of such a right is opposed to public policy as well. The right to sue is not an
actionable claim. It is thus, not a capital asset. It would not be accurate or correct to say that
such a right to sue for damages constitutes a capital asset as this was held in the case of CIT v.
Abbasbhoy Dehgamwalla7. A capital asset has to be an interest in property of any kind.

7
CIT v. Abbasbhoy Dehgamwalla, (1991) 59 Taxman 498 (Bom).

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HOW ARE SHORT TERM AND LONG TERM CAPITAL GAINS DIFFERENT FROM
EACH OTHER? HOW DIFFERENTLY ARE SHORT TERM ASSETS TAXED FROM
LONG TERM ASSETS?

Capital assets are classified into two major types that is short term capital assets and long term capital
assets. The gains that arise from the transfer of short term capital assets give rise to short term capital
gains while the transfer of long term capital assets give rise to long term capital gains. This
classification of short term and long term gains is important as that is what helps in the computation
of the amount of tax that is payable as well as the treatment of losses.

As the name for the two types goes, the incidence of tax on capital gains depends upon the length of
time for which the asset has been held before it is transferred.

Section 2(42A) makes an attempt to define short term assets. These have been defined in the section
as follows,

“a capital asset held by an assessee for not more than thirty-six months immediately preceding the
date of its transfer.”8

This means that ordinarily, a short term capital asset is held for 36 months or less where as any capital
asset held for more than 36 months is called a long term capital asset. However, there are certain
exceptions to this 36 month general holding period. Certain assets are regarded as short term assets if
held for 24 months or less and would be considered long term capital assets if they are held for a
period of more than 24 months. Certain other assets are considered to be short term assets if they are
held for a period of 12 months or less and would be considered long term if such assets were held for
a period that is longer than 12 months. A general list of properties or assets which fall under the 24
month exception are unlisted shares of companies, immovable property such as land or buildings. The
list of assets that fall under the 12 month exception are listed securities other than a unit, unit of equity
oriented mutual funds and zero coupon bonds.

Short term capital gains is computed in a manner where the cost of acquisition, cost of improvement
and the cost of transfer is all deducted from the full value of consideration for that specific short term
capital asset. So to put this in a mathematical equation format or in a formula,

Short term Capital gains = Full value of consideration – (Cost of acquisition + Cost of
improvement + cost of transfer)

Long term capital gains is computed in a manner where the indexed cost of acquisition, indexed cost
of improvement and the cost of transfer are all together subtracted from the full value of the
consideration received or accruing. When put in a mathematical formula,

8
Section 2(42A), Income Tax of India, 1961 (Act 43 of 1961).

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 Long term Capital gains = Full value of consideration received – (indexed cost of acquisition
+ indexed cost of improvement + cost of transfer)

[table 1, taken from How to compute capital gains booklet where, (CII = Cost of Inflation Index)] 9

Short term capital gains are also taxed differently from long term capital gains. The tax rate on short
term capital gains and long term capital gains are different and also there are certain exemptions
which are made available for long term capital gains.

In case of short term capital gains, excluding the securities transactions which are normally exempted
from applicability of tax, the short term capital gain which is accrued is added to the income tax. Then
depending on the income tax slab applied to the taxpayer, the taxpayer will be taxed. For short term
capital gains, when the securities transaction tax is applicable, the tax percentage is 15%. On the other
hand, long term capital gains except on sale of equity shares or units of equity oriented fund, the
taxpayer is taxed at the rate of 20%. In case of long term capital gains on the sale or transfer of equity
shares or units of equity oriented fund, the rate of tax levied is 10% over and above one lakh rupees.

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Supra Note 1.

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WHETHER IT IS BENEFICIAL FOR THE TAX PAYER TO INVEST IN SHORT-TERM OR
LONG-TERM ASSETS AND WHAT IS THE MOST EFFECTIVE ROUTE THAT THE
TAXPAYERS CAN EMPLOY TO GAIN THE MAXIMUM BENEFITS WHILE PAYING
THE LEAST TAXES ON CAPITAL GAINS?

Whether the taxpayer should invest in short term capital assets or whether the taxpayer should invest
long term capital assets depends on their individual tax planning and their individual incomes.
However, usually, it is beneficial to invest in long term capital assets as compared to short term
capital assets. This is due to the reason that the gains of the short term are taxed differently than the
gains of the long term.

The tax on short term capital gains is higher than that of the capital gains arising out of long term
assets. Let’s see how it is beneficial for most to invest in long term assets rather than short term
assets.

Short term capital gains are added to the income of the taxpayer and the taxes are applicable as per the
taxpayer’s slab rate except in cases of the sale of listed securities. It is also to be noted that in the case
of long term capital gains, the income arising from the long term assets is taxed in the range of 10%-
20% depending on what type of asset is transferred or sold. It also needs to be kept in mind that if
capital gains earned from long term assets such as the sale of listed shares is less than one lakh rupees,
it is not taxed.

“The investors, who have a lot of patience and pragmatism, are rewarded in accordance with the tax
laws. The tax rate you need to pay on a long term capital gain is significantly lower than the tax rate
on your regular income.”10

10
Taxmann, Difference Between Long-Term Capital Gains Tax and Short-Term Capital Gains Tax, last
accessed on Oct 28, 2020 at https://www.taxmann.com/blogpost/2000000383/difference-between-long-term-
capital-gains-tax-and-short-term-capital-gains-tax.aspx

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 CONCLUSION AND RECOMMENDATIONS

Capital gains tax is applied to the transfer of short term or long term capital assets. It needs to be kept
in mind that there are a few conditions that need to be met for the income from the transfer of a
property attract the capital gains tax. These are simple conditions such as that there needs to be a
capital asset and that such capital asset needs to be transferred. Further the capital asset should have
been acquired by paying a cost of acquisition of the capital asset and that there needs to be an accrual
of consideration for the transfer of capital asset.

Section 2 clause 14 of the Act in question has defined the term capital asset in an inclusive as well as
exclusive manner. That is to say that the definition has both negative and positive aspects to it. Capital
assets include any property other than those explicitly excluded from the definition. Over the years the
Courts through judicial pronouncements have clarified as to what can fall under the head of capital
asset for the purpose of capital gains tax. Intangible assets such as trademarks and goodwill are also
considered to be capital assets. However, there are certain rules that need to be followed to check
whether the intangible assets such as goodwill can be considered or not depends on a case to case
basis or depends on the facts of the case. Goodwill acquired in a newly established business is not
considered to be a capital asset.

The income or gains arising out of short term assets and the income or gains arising out of long term
capital assets are taxed differently and have different tax rates which apply. It has been noticed that
the rate of taxation of long term capital gains is less than that of the short term capital gains. Short
term assets are held for a period of 36 months or less ordinarily. Capital assets held for more than 36
months at a stretch, they are categorised as long term capital assets. However, there are certain
exemptions to this general rule and certain types of assets are considered to be short term if held for a
period of 24 months or less and certain other types of assets which are considered to be short term if
held for a period of 12 months or less. And these certain assets would be considered long term when
held for a period of more than 24 months while the certain other assets are held for more than 12
months.

It is thus, recommended that a person invest wisely and look to invest more in long term capital assets
as these tend to be taxed at a comparatively lower rate.

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