Among the various incomes that are reported when you file your income tax returns, capital gains is one of the key components. Intuitively, while long term capital gains (LTCG) refers to a longer holding perspective, at the shorter end is short term capital gains(STCG). Obviously, the government wants to encourage a longer term perspective among investors with respect to all asset classes. That is why LTCG always tends to get a more favourable tax treatment with respect to STCG. This is true of equity and all other classes too.
What is the logic of STCG and LTCG with respect to equities?
With a view to encouraging the equity cult in India, the Central Board of Direct Taxes (CBDT) has given a slightly more favourable treatment of the time frame with respect to equities. For all the asset classes, LTCG is classified as a minimum holding period of 36 months (3years). This definition applies to asset classes like land, apartments, gold investment ,debt mutual funds investment, bonds etc. However, in case of equities, there is a special treatment that is accorded with respect to the definition of LTCG and STCG.Unlike other asset classes, the definition of LTCG is when the equity is held for a period of more than 12 months (1 year). In case equities are sold in less than 12 months then it will be classified as STCG. The definition of equity is quite wide in this case and includes primary market IPOs, secondary market equities and equity mutual funds. In addition, this preferential LTCG treatment is also available to hybrid funds like Balanced Funds and Arbitrage Funds where more than 65% of the holding is in equities.
How are LTCG and STCG taxed in case of equities?
Just as equities get preferential treatment with respect to the definition of LTCG and STCG, they also enjoy the additional benefit of preferential rates of taxation in both the cases. For example while other assets have to pay tax on LTCG at 20% after considering indexation, in case of equities LTCG is entirely tax free. That means if you bought equity shares today and sold it after 12 months then the entire capital gains made by you is entirely tax-free in your hands irrespective of the quantum of capital gains made by you. Even in case of STCG there is preferential treatment for equities. In case of other assets, STCG is taxed at your peak rate of tax by inclusion under the head of “Other Income”. So if you are in the 30% tax bracket then in case of non-equity assets you will have to pay tax at your peak rate of 30%. However, in case of STCG on equities, you are only required to pay tax at a concessional rate of 15%. Thus both in case of LTCG and STCG, equity and equity-related products tend to get preferential treatment.
How to treat long term and short losses on equities?
It would be naive to expect that you will only make profits in equities. As past experience has shown, you are as likely to make losses in any year, in fact more so, as you are likely to make profits.So, how do you treat losses in case of equities? The Income Tax Act gives you the benefit of writing off losses against gains and also to carry forward your losses for a period of 8 financial years. In case of equities, the treatment is slightly more complicated.
In case of LTCG, since they are entirely tax free in the hands of the investor, long term losses do not have the benefit of carry forward or set-off. So if you bought shares at Rs.50,000 and sold the same at Rs.40,000 after 1 year, then that being a long-term loss can neither be set off against other income nor can it be carried forward. STCG, however, gets a slightly different treatment. Since STCG on equities is taxed at 15%, any short term losses can be set off against short term profits. Also these losses can be carried forward for a period of 8 years and set off against future profits.However, since STCG is preferentially taxed at 15%, short term losses cannot beset off against other sources of income.
Does indexing apply in case of equities?
Indexing is the process of claiming benefit of inflation adjustment to your asset cost so that your actual profit becomes more realistic. Indexation is based on an annual index number that is announced by the CBDT each year. It is only applicable in case of long term capital gains.However, in case of equities, since long term capital gains are entirely tax free in the hands of the investor, the question of indexation is not applicable.
Understanding the nuances of LTCG and STCG can go a long way in understanding the merits and demerits of your equity actions vis-a-vis other asset classes. Remember, equity does get preferential treatment in the definition and rates of capital gains tax and that must be factored into your financial plan!