Capital Mind How To Calculate Long Term Capital Gains Tax

Post on: 16 Март, 2015 No Comment

With Indexation

The government understands that you might buy a product this year, but sell it after a few years. But in the process, inflation has destroyed the value of your money i.e. what might cost Rs. 100 today might cost Rs. 130 in five years (assuming 5.4% inflation remember, inflation is compounded). So if you sell the product after five years for Rs. 150, your gain really is Rs. 20.

To calculate this actual gain, the Income Tax department releases a cost-inflation-index (CII) figure every year. Usually, in May, it will release the CII for the last financial year so the CII for 2010-11 will be released in May 2011. And its not easy to find; but luckily enough people get to know and Google becomes a good friend.

Effectively, the cost of acquisition becomes substantially lower. The formula is:

Indexed Cost of Acquisition = (Actual cost of purchase) * (CII Of Year of Sale)/(CII of Year of Purchase).

Capital Gain = (Sale Price MINUS Indexed Cost of Acquisition).

Capital Gains Tax = 20% of Capital Gain

For example, if you bought 1000 units of a debt fund at Rs. 50 per unit in 2008-09 and sold the 1000 units in 2009-10 for Rs. 55, then:

(Purchase Price = Rs. 50,000 and Sale price = 551000 = Rs. 55,000)

a) Indexed Cost of Acquisition = 50,000 x (632/582) = 54,295.

b) Capital gain = 55,000-54,295 = 705.

c) Capital Gains tax = 20% of 705 = Rs. 141.

The indexation benefit allows you to let inflation take its toll on the purchase price; there is no such allowance for short term capital gains, in a mutual fund or stock sold within a year of purchase. In that case, the gain (non-indexed) is simply added to your income and your income is taxed appropriately, and that effectively means short term capital gains are taxed at the highest slab that applies to you.

The indexation benefit also substantially increases your post-tax return when you use a mutual fund rather than, say, a fixed deposit. The mutual fund is indexed for inflation, but the FD return is not (even the annual interest for a multi year deposit is added to your gross income and taxed).

Without Indexation

To make life a little simpler, there is an allowance to ditch the entire indexation concept, where you have sold a mutual fund (or a stock outside the stock exchanges, say in a buyback offer). The idea is: your non-indexed capital gain = Sale Price MINUS purchase price. On that you pay just 10%.

You can choose with indexation or without indexation for every asset sale for the total capital gain that you have. In some cases it may be better to pay just 10%. For instance if you bought a stock 10 years ago, chances are it has multiplied so much that any amount of indexation doesnt cut much into your profits; you are then better off paying 10% of the unindexed gain rather than 20% of indexed gains.

Note. Reader Px noted that the IT department may not allow part of such debt mutual fund gains to be indexed and part not to be. This means you have to calculate your total gains with such indexation, and then without such indexation. Then see if the taxes are different on the two. That makes sense, but is complicated in the sense that you dont get the best benefit on your assets if you sell a lot of them. But I admit this looks like something the IT department will allow more than my earlier assumption (i.e. choose indexation or not for each asset sale). I have changed the post my apologies.

Example: Different purchase dates and FIFO

Now I will complicate matters. If you have bought :

* 1000 units at Rs. 10 on 1 Jan 2008,

* 1000 more units at Rs. 15 on 1 May 2008

* 1000 more units at Rs. 16 on 1 December 2008

and sold

* 2500 units at Rs. 17 on 30 December 2009,

How are the gains calculated?

Answer: Each purchase/sale transaction is matched on a First-In-First-Out basis. This is like a queue the first person who is in the queue gets serviced first and get out, then the next and so on. Versus a LIFO or Last-In-First-Out, like in a crowded lift or a metro train where the last person in usually ends up getting pushed out before others can leave. The IT department needs FIFO.

All the units sold have been held for over one year, so long term capital gains tax applies.

So here, out of the 2,500 units sold, we have three separate pieces to be considered.

The First 1000 are matched to the first 1,000 bought, appropriately indexed, gains calculated and tax calculated.

Here you get two years of Indexation (2007-08 and 2008-09) because the purchase to sell dates span two financial years Jan 08 to December 09.
Indexed Purchase Price = 10,000 * (632/551) = 11,470.
Capital Gain = 17,000 11,470 = 5,530

The non-indexed gain is Rs. (17,000-10,000) = Rs. 7,000.

Indexed Capital Gain: Rs. 5,530

Non Indexed Capital Gain: Rs. 7,000

The Next 1000 units get one years indexation because they are off by just one financial year (Jun 2008 to Dec 2009) These were purchased for Rs. 15,000.