Government Budgets

On discarding indexation for LTCG    

Explained | Economics | Mains Paper 3: Indian Economy
Note4Students

From UPSC perspective, the following things are important :

Prelims level: Indexation, Capital Gains Tax Regime.

Mains level: Significance of indexation

Why in the news?

Finance Minister Nirmala Sitharaman’s decision to eliminate indexation for calculating long-term capital gains (LTCG) tax in the Union Budget has received a lukewarm response from stakeholders.

Changes in the LTCG Regime

  • The new LTCG regime removes the indexation benefit for property, gold, and other unlisted assets.
  • The LTCG tax rate is reduced from 20% to 12.5%.
  • For assets purchased before 2001, the fair market value as of April 1, 2001, is considered the cost of acquisition.

What is long-term capital gains (LTCG) tax? 

  • LTCG refers to the profit realized from the sale of an asset that has been held for more than one year. This includes various types of assets such as stocks, bonds, real estate, and mutual funds. 
  • If an asset is sold before this holding period, the gains are classified as short-term capital gains (STCG) and are taxed at different rates.

Why has the Union Finance Minister done away with indexation for computing long-term capital gains (LTCG) tax?

  • Simplification of Tax Computation: The Finance Minister proposed the change to “ease computation of capital gains for the taxpayer and tax administration.” The intention is to simplify the tax process.
  • Uniform Tax Rate: Long-term gains on all financial and non-financial assets would now be taxed at a flat rate of 12.5%, replacing the previous tiered structure.
  • High real estate return: The Income Tax department believes that the real estate returns (12-16% per annum) are higher than indexation for inflation (4-5%). Thus, it predicts “substantial tax savings” for a “vast majority” of taxpayers under the new system.

What is indexation?

  • Indexation is a mechanism used to adjust the original purchase price of an asset to account for inflation. It helps in calculating the real gains and prevents inflation from inflating the tax liability. The adjusted purchase price is called the indexed cost of acquisition.

How does Indexation help in Tax Savings?

  • Adjusts the purchase price for inflation: Indexation increases the original purchase price of an asset to account for inflation between the time of purchase and sale. This results in a lower taxable capital gain.
  • Reduces the taxable capital gains: By revising the purchase price upwards using the Cost Inflation Index, indexation reduces the difference between the sale price and purchase price. This lowers the taxable capital gains amount.
  • Leads to lower tax liability: With a reduced taxable capital gain, the tax payable on it also decreases. For example, on a ₹48 lakh gain from selling a house, indexation can bring down the taxable gain to ₹28.6 lakh, saving ₹4,264 in tax (assuming 20% LTCG rate).

What has been the feedback from corporates and industry regarding the move?

  • Concerns Over Increased Tax Liability: Many stakeholders expressed apprehension that the removal of indexation would lead to higher tax obligations for ordinary investors, particularly in the real estate sector.
    • There are fears that this might encourage the undervaluation of properties to reduce capital gains tax and potentially increase black money transactions in real estate.
  • Mixed Reactions from Realty Players: While some real estate developers and consultants indicated that the removal of indexation might not significantly impact demand and prices, especially for primary home buyers, they noted that high-end properties could see a drop in demand.
    • Some developers viewed the changes positively and said that the lowered tax rate (from 20% to 12.5%) could make real estate a more attractive long-term investment.
  • Government Justifications and Clarifications: The government has argued that the new tax regime simplifies the capital gains tax structure and is beneficial for most taxpayers.

Way forward: 

  • Transitional Provisions: Govt. should implement transitional provisions for existing investments to ease the shift from the old system to the new one.
  • Strengthen the monitoring system: Need to strengthen monitoring mechanisms to prevent the undervaluation of properties and reduce black money transactions.

Mains PYQ: 

Q Comment on the important changes introduced in respect of the Long-term Capital Gains Tax (LCGT) and Dividend Distribution Tax (DDT) in the Union Budget for 2018-2019. (UPSC IAS/2018)

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