Capital Gains – Profit-Loss, Taxability and Exemptions
INTRODUCTION
It is quite common these days to have multiple sources of income, people tend to lean on rental incomes, interest incomes, shares, mutual funds among many others.
For the taxation purpose, govt. has divided all such sources in 5 heads namely Salaries, House Property, Profit from business and profession, Capital gain, and Other sources.
A brief description of all is as follows:
- Salaries – Every income arising out of an employee-employer situation falls under this head.
- House property – Rental incomes from any type of house property is taxable here.
- Business and profession – Income or profits from your business or profession in aggregate will fall under this head.
- Capital gain – profit from selling assets is taxable under this head.
- Other source – Every other source of income apart from above falls under this head.
Capital Gain
Capital Gain, the gains that one earns from selling assets which are either personal or capital in nature. Well that was pretty obvious and much oblivious at the same time. So when someone sells their asset for more than its purchase price, it results in profit which is required to be taxed if the asset sold qualifies to be a capital asset.
Not all the assets qualify for capital gain tax. As per Income Tax rules and provisions, all the assets are divided into different categories depending on their nature and use-case. So as all of you know, assets are represented on one side of the balance sheet and we all might have seen at least one balance sheet in our life. Although everyone is not required to have their balance sheet, usually proprietors with business income, partnerships and corporations regularly have their balance sheets made and also get audited.
Types of Assets
Assets of an organization can be classified into so many categories given the criteria, e.g., Capital assets, Tangible assets, Intangible assets, Fixed assets, Deferred assets, Current or Non-current assets among other classifications.
For the purpose of this article, let’s just keep it simple and divide all the assets in two categories, i.e. Capital assets and Ordinary assets. Let me give you the understanding using an example. Suppose, Mr. Arvind wants to set up a small business of designer fabric with exquisite hand-work. For this, he rented a showroom and got it furnished with a beautiful interior, air conditioners, counters, furniture, mirrors, televisions and other necessary items.
Mr. Arvind also purchased fabrics, threads and other supplies to be used on such fabrics. These fabrics after all the craftsmanship is sold at the showroom.
In this example, Furniture, air conditioner, machines, television and all other things would classify as capital assets whereas the fabric, thread and other supplies would classify as stock. Therefore, we can define capital assets as the assets which help in establishing the business and the benefit would accrue over multiple years whereas stock (ordinary assets) are those assets which are dealt in day-to-day activities to achieve the primary or core objective of the business.
Gain from selling assets
Selling your assets for more than its cost will result in gain, however the taxability of such gain will depend on the nature of asset among other factors.
1. Stock (ordinary assets/trading assets)
Basically, when a business sells stocks, the profits from those sales count as part of the business’s income and are taxed because selling stocks is the main thing the business does.
2. Capital assets
Sometimes to effectively run a business, capital assets need to be sold or disposed off. But since selling these assets is not the primary objective of the business, gains arising from selling these can not be considered as business income but rather income from capital gains.
Capital assets
Under Income tax rules, capital assets have been classified into different categories to imply different tax rules, tax rates and exemptions to them. But for the purpose of this article, we are going to discuss only the common and trending assets. These common assets are properties, gold, jewellery, deposits, shares, mutual funds. Crypto assets and personal assets.
Taxation
For taxation purposes, duration of owning the asset can have a huge impact on the tax liability. Income tax rules divide the duration into short-term and long-term of holding which may differ for different assets. For simplification, let’s group the above assets into clusters.
Shares, mutual funds and ULIPs – holding period of more than one year is considered as long term holding.
Property and Land – holding period of more than two years is considered as long term holding.
Others – For the rest of the assets, three years of holding is considered as long term holding.
These classifications have been made to promote investments in different instruments for a longer time. For example, investments in fixed deposits would classify as long term investment if held for more than 3 years whereas investment in stock market via stocks or mutual funds would require only 1 year of holding period to classify as long term investment for taxation purposes.
This is designed to promote investments in the stock market which contribute more to the economy than a fixed deposit. There are multiple factors which are considered while deciding the long-term and short-term nature of the investment.
These thresholds of period of holding bifurcates the assets into long-term assets and short-term assets, which is very necessary for calculations of taxes, rebates and exemptions on the gains earned.
Although the investor is always free to sell his/her assets at any period of time which suits best, but through these bifurcation, long-term holding of the assets are encouraged since it results in keeping money in the economic cycle for a longer period of time which in turn enable the investments houses can hold positions for longer period of time.
Example 1 – Banks are supposed to keep a certain amount of total deposit as cash, as mandated by RBI, but keeping deposit as cash with itself means that money is lying idle. So when someone makes a fixed deposit for a shorter period of time, the bank is not able to effectively invest that money further knowing that the maturity is not far. Whereas, if FD is made for a longer period of time, the bank could loan that amount further for a longer period of time.
Example 2 – Suppose X made an investment in a mutual fund and that mutual fund house invests in such companies that have potential to grow. Short period of investments forces these mutual fund managers to skip such companies or they could invest in those companies only to sell in recent future without earning the potential return just because Mr. X and other people like him withdrew money from their mutual fund investment.
Apart from this bifurcation, the Government also provides for different rates of taxes for different combinations of type of asset and period of holding. For example shares and equity mutual funds are taxed at 15% rate of tax if held for less than 12 months whereas taxed at 10% rate of tax if held for more than 12 months.
Therefore, these factors should be considered thoroughly before investing. It is common for shares and mutual funds to give better results if held for a longer period of time. Consult an expert and try to ask as many questions as it takes to choose the best instrument for your investment, for an optimal period of time. Choose wisely!!
