Background of introduction of Capital Gains-tax in India

A tax on capital gain was levied in 1947. The justification for a capital gain tax at that time was that the war had led to a large increase in prices and gains made from the sale of property were unearned increments.

There is stabilization objective behind taxation of capital gains as well since in times of property more tax can be realized from capital gains. Since the taxation of capital gains is more important to the influential class of society than the treatment of any other type of income it has been extremely controversial over the years.

Justification of Capital Gains Tax

The main benefits of capital gains tax are listed below :

(i) MORE EQUITABLE:

It is argued that capital gains tax is more equitable and that it can be used as a counter-cyclical measure. The strongest argument is that the person making capital gains attains larger capacity to pay.  Therefore, equity principle demands that the capital is to be taxed. Capital gains are a highly progressive source of income to the rich. The rich reinvest their capital gains which become recurring with time. Hence, in the absence of capital gains tax, the inequality of income will be widened.

(ii) HELPFUL DURING INFLATION:

During inflation, the value of capital rises and capital gains occurs. If capital gains tax is progressive, then a large part of the capital gains will be taken away by taxation. This will help controlling inflation. In the reverse situation of deflation when the value of capital falls and hence, capital gains decline, the rate of capital gains tax will decline more than in proportion to decline in capital gains. This will check deflation.

Background of introduction of Capital Gains-tax

Till the year 1946, Capital gains were not taxable in India. During and after the Second World War, there was steep inflation in the country and people not only earned substantial profit, but the value of capital assets also appreciated substantially. It was in this background that the budget of 1947 introduced capital gains-tax with effect from assessment year 1947-48. While justifying its imposition, the Finance Minister observed that “there is a stronger justification for taxing these profits than for taxing ordinary income, since they represent what is properly described as unearned increment.”

Abolition of capital gains-tax

With effect from 01.04.1949, the levy of tax on capital gains did not remain in effect for long, as it was deleted by the Finance Act of 1949, with effect from assessment year 1949-50 on the ground that its yield was very poor and that it discouraged investment. Thus the levy of capital gains-tax remained on statute book only for two assessment years viz., 1947-48 and 1948-49.

Although imposition of tax on capital gains was justified, it was abolished in the year 1949 on account of its unpopularity, low yield of revenue and adverse effect on the investment and movement of capital. While explaining its abolition, the Finance Minister stated in his budget speech that “its psychological effect on investment has, however, been markedly adverse and it has had the effect of hampering the free movement of stocks and shares without which it is hardly possible to maintain a high level of industrial development”.

Thus the tax was short-lived and discontinued after two years. Capital gains between 01.04.1946 and 31.03.1948 were liable to tax. The non-taxable maximum limit was fixed at Rs. 15,000. In computing them the taxpayer was given the option to adopt, instead of the actual cost of the asset, its fair market value as on 01.04.1939. In the case of non-company taxpayers, special rates of tax were prescribed ranging from one anna in the rupee (6.25%) on capital gains upto Rs. 50,000 to five anna (31.25%) in the rupee on gains above Rs. 10 lakhs. In the case of companies the tax was not to be charged if the amount  of capital gains did not exceed Rs. 15,000. But where the gains exceeded this amount the whole of it was taxed. The rate of tax for companies was the ordinary income-tax rate applicable to them. In order to remove the apprehension that “losses claimed may exceed the profits declared”, it was provided that capital loss could be set-off only against capital gain and such loss could be carried forward for six years only if it exceeded Rs. 15,000 in any year for non-corporate taxpayers.

Prof. Nicholos Kaldor’s recommendation

In the year 1955, Prof. Nicholas Kaldor was invited to recommend tax reforms after studying the existing system of taxation in India. He was entrusted with the job of suggesting reforms in Indian Tax Structure argued strongly in favour of levy of capital gains tax. He not only found fault with the reasoning for which the levy of capital gains-tax was abolished but also criticized the approach in this regard. He was also of the view that the full yield potential of the tax should only become apparent after it had been in operation for 10 to 20 years and, therefore, it would be a great mistake to treat the taxation of capital gains mainly on short-term revenue considerations. He defended the levy of capital gains tax mainly on the ground of equity in taxation as it involves the privileged treatment of the particular class of taxpayers as against others. He found exclusion of capital gains from the scope of Income taxation quite indefensible on the ground of administrative efficiency also, since it enables taxpayers to camouflage income as tax-exempt gain and to conceal gain. According to him, so long as the extent of taxation is based on “income”, the only impartial concept of income is that which treats all realized gains equally.

In view of the above argument, Prof. Kaldor recommended re-introduction of the tax at the earliest.

Re-introduction of capital gains-tax in respect of transfers after 31.03.1956

After submission of report by Prof. Kaldor Committee to levy tax on profits arising on sale/transfer of specified non-inventory asset, the government reintroduced the levy of capital gains-tax by Finance Act (No. 3) of 1956 (Special Budget of 1956-57). By the said Act, the Government substituted section 12B by a new section which apart from making minor changes consequential to introduction of Constitution of India in 1950 included changes with regard to following:—

(i) Definition of capital asset remained same.

(ii) The basic exemption limit of  Rs. 15,000/- was reduced to Rs. 5,000/-.

(iii) The assessee was given option to substitute the “fair market value” of the assets as on 01.01.1954 in place of cost of acquisition where the assets were acquired prior to 1954.

The non-taxable limit was fixed at Rs. 5,000 for non-company taxpayers, with no liability to pay tax if the total income, including the capital gains, did not exceed Rs. 10,000. One-third of such gains would be added to the other income, and the income-tax rate applicable to the sum so arrived at would be the rate at which the whole of these gains would be taxed. In the case of registered firms, to attract tax, capital gains must exceed Rs. 5,000 and total income, Rs. 40,000. As regards companies, the full amount of such gains was taxable as income. Losses could be set-off, as before, only against capital gains, but, could now be carried forward indefinitely provided the capital loss sustained in any ‘previous year’ exceeded Rs. 5,000.

Since 1956, the tax treatment of capital gains has been the subject-matter of investigation by various individuals and committees such as S. Bhoothalingam in 1968, the Direct Taxes Enquiry Committee in 1971, the Direct Tax Laws Committee in 1978 and Economic Administration Reforms Commission in 1983 who have studied the taxation of capital gains and made some recommendations. Consequently, almost every Finance Act contains some provision/change in laws relating to capital gains taxation.

FIRST PHASE

Section 114 which was substituted first by the Finance Act, 1962 with effect from 01.04.1962, deals other than companies omitted by the Finance Act, 1967 with effect from 01.04.1968 re-introduced with material modifications in section 80T. (Deduction in respect of long-term capital gains in the case of assessees other than companies)

Section 115 which deals with tax on capital gains in case of companies inserted by Finance Act, 1962 with effect from 01.04.1962 and omitted by the Finance Act, 1987 with effect from 01.04.1988.

SECOND PHASE

The relevant provisions of capital gains scattered in the form of section 80T under Chapter VI-A and section 115 under Chapter XII in the form of a new section 48.

THIRD PHASE

With effect from assessment year 1993-94, Tax Reforms Committee, 1991 looked into various aspects of taxation of capital gains. As per recommendations of Tax Reforms Committee, measures like indexation for inflation were introduced.

BUDGET : 2004-05

Abolished long-term capital gains on equity and reduced the levy of shortterm capital gains to 10% from normal rates. This budget also introduced a new tax called Security Transaction Tax (STT). Several countries have considered Security Transaction Tax (STT) either as a substitute for capital gains tax or as an independent tax. The general trend has been to impose either capital gains tax or Security Transaction Tax (STT). There are also instances of both types of taxes prevailing simultaneously such as in France and Denmark. Security Transaction Tax (STT) is imposed in one form or other in several countries like Argentina, Australia, Belgium, Brazil, China, France, Greece, Italy, Indonesia, Malaysia, Pakistan, Singapore, UK and Zimbabwe.

Present scenario

At present, Part E of Chapter-IV of the Income Tax Act, 1961 (hereinafter referred to as the Act) consisting of sections 45 to 55A exclusively deals with taxation of capital gains. As a result of constant evolution, capital gains tax, as it stands today, is levied on transfer of all capital assets (other than held as stock-in-trade) with a computation mechanism prescribed under sections 45 to 55A of the Act. Over the past two decades, several exemptions were incorporated in the statute to rationalize the levy with a view to mitigate “undue hardship” to the taxpayers.

Residential status for the purpose of taxation of Capital gain

(a) Where the assessee is a resident of India

Ø  capital gains arising to him by transfer of his foreign assets would suffer taxation since, a resident is chargeable to tax also on his income accruing or arising abroad.

(b) Where the assessee is a non-resident

Ø  any profits or gains accruing to or received by him abroad or on the transfer of any of his capital assets situate abroad would not be taxable. His liability for capital gains taxation would be restricted to capital gains in respect of assets, if any, situate in India.

Capital gains are chargeable on accrual basis

It is not necessary that the consideration should be received in the year of transfer itself. Capital gains are chargeable on accrual basis.

Capital gains tax is payable in year in which assessee has acquired a right to receive profits, and its actual receipt in that year is not necessary.—[T. V. Sundaram Iyengar & Sons Ltd. v. CIT (1959) 37 ITR 26 (Mad)]

Mercantile method of accounting has to be followed

Under the head ‘capital gains’ is concerned, a taxpayer has no option but to follow the mercantile method of accounting. In other words, capital gains are chargeable to tax in the year in which the asset is transferred irrespective of whether the sales consideration is actually received.

MERCANTILE OR ACCRUAL METHOD

Under this method, transactions are considered as and when they are incurred or earned whether they are received or not.

Receipt of consideration in installments

Even in that case also the entire consideration has to be taken into account for computing the capital gains.

 

No capital gains where sale itself declared null and void

The assessee transferred a certain amount of land and computed capital gains therefrom. But the district collector declared the sale as null and void under section 4 of the Gujarat Vacant Lands in Urban Area (Prohibition of Alienation) Act, 1972 which prohibited alienation of land in any vacant area after the commencement of the Act by way of sale, gift, exchange, etc. The court held that as there was no sale transaction in the eye of law, there could be no capital gain arising out of a null and void transfer of such land. - [CIT v. Vithalbhai P. Patel (1998) 236 ITR 1001 (1999) 7 DTC 62 (Guj)]

 

Provisions relating to capital gains should be construed strictly

It was held that capital gains is an artificial income created by the provisions of the Act and as a result provisions relating thereto should be strictly construed. In case of doubt, the assessee would be entitled to the benefit of doubt. - [CIT v. Bhupender Singh Atwal (1983) 140 ITR 928 (Cal)]

 

Capital gain is part of income though under separate head

Capital gain is a part of income and capital gains tax is not to be regarded as an additional or separate tax distinct from income-tax. This is based upon the principles laid down by the courts that income-tax is only one tax and it is wrong to assume that there are as many items of taxes as there are heads of income or sources of income. - [Karanpura Development Co. Ltd. v. CIT (1962) 44 ITR 362 (SC); K. V. AL. M. Ramanathan Chettiar v. CIT (1973) 88 ITR 169 (SC); Smt. Abida Khatoon v. CIT (1973) 87 ITR 627 (AP)]

 

One deeming section cannot be extended by importing another deeming section

Deeming fiction cannot be extended by importing another deeming fiction for the purpose of determination of full value of consideration. – [CIT v. Moonmill Ltd (1966) 59 ITR 574 (SC)]

 

Capital gains in case of erstwhile State Ruler

It was held that in the case of an erstwhile State Ruler what is exempt is the annual value of official house of such ruler. But the exemption could by no stretch of imagination be held to embrace income in the nature of capital gains realized on sale of land forming part of the official residence of a ruler.—[Smt. Maharani Usha Devi v. CIT (1961) 131 ITR 445 (MP)]

Definitions

 

S. No.	Section	Definition of
(i)	2(1B)	Amalgamation
(ii)	2(14)	Capital Asset
(iii)	2(19AA)	Demerger
(iv)	2(22B)	Fair Market Value
(v)	2(29A)	Long-Term Capital Asset
(vi)	2(29B)	Long-Term Capital Gain
(vii)	2(42A)	Short-Term Capital Asset
(viii)	2(42B)	Short-Term Capital Gain
(ix)	2(42C)	Slump sale
(x)	2(47)	What is transfer
(xi)	2(48)	Meaning of Zero Coupon Bond

It is pertinent to note that the “Capital Gains” is not defined in the Act. However, it defines “Capital Asset”.

(i) 10(33)	Capital gain on transfer of Units of US 64
(ii) 10(36)	Long-term capital gain on eligible equity shares
(iii) 10(37)	Capital gains on compensation received on compulsory acquisition of agricultural land situated within specified urban limits
(iv) 10(38)	Capital gain arising from sale of shares and units
(v) 10(41)	Exemption of capital gain on transfer of an asset of an undertaking engaged in the business of generation, etc. of power

Sections dealing with taxation of income from Capital gains

In order to have an overview on capital gains taxation, we shall see the sections of Income Tax Act, 1961 dealing with capital gains taxation. The sections are as given below:—

 

S. No.	Section	Contents
1.	45	Capital gains—Basis of Charge
2.	45(1A)	Capital gain arises from insurance claim received for demage or destruction of a capital asset.
3.	45(2)	Capital gain conversion of capital asset into stock-in-trade.
4.	45(2A)	Transfer of securities by depository
5.	45(3)	Capital gain on transfer of a capital asset by a person to a firm/AOP as capital contribution
6.	45(4)	Capital gain on transfer of capital asset by way of distribution on dissolution of a firm/AOP
7.	45(5)	Capital gain on transfer by way of compulsory acquisition of an asset
8.	45(5A)	Special provisions for computation of capital gains in case of Joint Development Agreement (JDA)
9.	45(6)	Capital gain on repurchase of units of mutual funds under Equity Linked Savings Schemes
10.	46	Capital gains on distribution of assets by companies in liquidation
11.	46(1)	Whether capital gain arises to company or not
12.	46(2)	Whether capital gain arises to shereholders
13.	46A	Capital gains on purchase by company of its own shares or other specified securities
14.	47	Transactions not regarded as transfer
15	47A	Withdrawal of exemption in certain cases
16.	48	Mode of computation of capital gain
17.	49	Cost with reference to certain modes of acquisition
18.	49(1)	Cost to the previous year
19.	49(2)	Cost of shares of amalgamated companies
20.	49(2A)	Cost of acquisition in the case of shares acquired on  conversion of debentures
21.	49(2AA)	Cost of acquisition of shares, etc. under ESOP
22.	49(2AAA)	Cost of the partnership rights of a partner on conversion of a company into LLP
23.	49(2AB)	Cost of shares issued under ESOP if such shares have already been subject to FBT under section 115WC(1)(ba)
24.	49(2ABB)	Cost of acquisition of share or shares of a company acquired by the non-resident on redemption of Global Depository Receipts
25.	49(2AC)	Cost of acquisition of Unit of a business trust acquired in consideration of transfer of asset referred to in section 47(xvii)
26.	49(2AD)	Cost of acquisition of the Units of the consolidation scheme acquired in lieu of units held in a consolidating scheme
27.	49(2C)	Cost of acquisition of shares in the resulting company
28.	49(2D)	Cost of acquisition of the original shares of the demerged company
29.	49(2E)	Cost of acquisition of the shares of the resulting  Co-operative bank and demerged Co-operative bank
30.	49(3)	Cost of acquisition when exemption is withdrawn under section 47A
31.	50	Special provision for computation of capital gains in case of depreciable assets
32.	50A	Special provision for cost of acquisition in case of depreciable asset
33.	50B	Special provision for computation of capital gains in case of slump sale
34	50C	Special provision for full value of consideration in certain cases
35.	50CA	Special provision for full value of consideration for transfer of share other than quoted share.
36.	50D	Fair Market Value (FMV) deemed to be full value of consideration in certain cases
37.	51	Advance money received
38.	54	Profit on sale of property used for residence
39.	54B	Capital gain on transfer of land used for agricultural purposes not to be charged in certain cases
40.	54D	Capital gain on compulsory acquisition of lands and buildings not to be charged in certain cases
41.	54E	Capital gain on transfer of capital assets not to be charged in certain cases
42.	54EA	Capital gain on transfer of long-term capital assets not to be charged in the case of investment in specified securities
43.	54EB	Capital gain on transfer of long-term capital assets not to be charged in certain cases
44.	54EC	Capital gain not to be charged on investment in certain bonds
45.	54ED	Capital gain on transfer of certain listed securities or unit not to be charged in certain cases
46.	54EE	Capital gain not to be charged on investment in units of a specified fund [w.e.f. 1-4-2017]
47.	54F	Capital gain on transfer of certain capital assets not to be charged in case of investment in residential house
48.	54G	Exemption of capital gains on transfer of assets in cases of shifting of industrial undertaking from urban  area
49.	54GA	Exemption of capital gains on transfer of assets in cases of shifting of industrial undertaking from urban area to any Special Economic Zone
50.	54GB	Capital gain on transfer of residential property not  to be charged in certain cases
51.	54H	Extension of time for acquiring new asset or  depositing or investing amount of capital gain
52.	55	Meaning of “adjusted”, “cost of improvement” and  “cost of acquisition”
53.	55(1)(b)	Cost of improvement
54.	55(2)	Cost of acquisition
55.	55(2)(a)	Cost of acquisition of goodwill of a business, etc.
56.	55(2)(aa)	Cost of acquisition of bonus and right shares
57.	55(2)(ab)	Cost of acquisition of equity shares allotted to the  shareholder of a recognized stock exchange on corporatization
58.	55(2)(ac)	Cost of acquisition in respect of capital assets referred to in section 112A
59.	55(2)(b)	Cost of acquisition of assets acquired before 01.04.2001
60.	55(3)	Where cost of previous owner is not ascertainable
61.	55A	Reference to Valuation Officer
62.	70	Set off of loss from one source against income from another source under the same head of income
63.	71	Set off of loss from one head against income from another
64.	74	Losses under the head “Capital gains”
65.	111A	Tax on short-term capital gains in certain cases
66.	112	Tax on long-term capital gains
67.	112A	Tax on Long-term capital gains in certain cases  (w.e.f. 1-4-2019)
68.	115AB	Tax on income from units purchased in foreign currency or capital gains arising from their transfer
69.	115AC	Tax on income from bonds or Global Depository Receipts purchased in foreign currency or capital gains arising from their transfer
70.	115ACA	Tax on income from Global Depository Receipts purchased in foreign currency or capital gains arising from their transfer
71.	115AD	Tax on income of Foreign Institutional Investors from securities or capital gains arising from their transfer
72.	115E	Tax on investment income and long-term capital gains
73.	115F	Capital gains on transfer of foreign exchange assets not to be charged in certain cases
74.	115-I	Option not to avail of the provisions of section 115F
75.	194-IA	Payment on transfer of certain immovable property other than agricultural land
76	194-LA	Payment of compensation on acquisition of certain immovable property