Capital Gains, Tax Bonds and Section 54EC

Student Research Project (Posted on 10/10/2006)

What are capital gains?

Any gain arising from the transfer of a capital asset during a previous year is rechargeable to tax under the head “Capital Gains” in the immediately following assessment year, if it is not eligible for exemption under sections 54, 54B, 54D, 54EC, 54ED, 54F and 54G. In other words capital gains tax liability arises only when the following conditions are satisfied:

In the foresaid conditions are satisfied, then capital gain is taxable in the assessment year relevant to the previous year in which the capital asset is transferred. However the following points should be considered-

1. In some cases capital gain taxable in a year other than the year in which the capital asset is transferred.

2. In some cases capital gain arises even if there is no transfer of capital asset.

What is a transfer for the purposes of capital gains?

1. Section 2(47) of the Income Tax Act, defines transfer in relation to capital asset, and it includes

• The sale, exchange or relinquishment of the asset; or

• The extinguishment of any rights therein ; or

• In case where the asset is converted by the owner thereof into, or treated by him as, stock-in-trade of a business carried on by him, such conversion or treatment;

• Any property transaction involving the allowing of the possession of any immovable property to be taken or retained in part performance of any immovable referred to in section 53A of the Transfer of the Property Act, 1882(4 of 1882); or

• Any transaction (whether by way of becoming a member of, or acquiring shares in, a co-operative society, company or other association of persons or by way of any agreement or in any other manner whatsoever) which has the effect of transferring or enabling the enjoyment of, any immovable property.

• Explanation – For the purposes of sub-clauses (v) and (vi), “Immovable property” shall have the same meaning as in clause (d) of section 269UA.

CAPITAL ASSET

“Capital asset” is defined to include property of any kind, whether fixed or circulating, movable or immovable, tangible or intangible. The following assets are however excluded from the definition of “capital assets”.

“Short term capital asset’ means a capital asset held if a capital asset is held by an assessee for not more than 36 months, immediately prior to its date of transfer. In other words if a capital asset is held by an assessee for more than 36 months, then it is known as “long-term capital asset”.

Computation of short term and long term capital gain

-- Short term capital gain

• Find full value of consideration

• Deduct expenses on transfer, cost of acquisition, cost of improvement

• Deduct exemption u/s 54B, D and G.

• The balancing amount is Short term capital gain

• Deduct the expenses on transfer, indexed cost of acquisition, indexed cost of improvement

• Deduct exemption u/s 54B, D, EC, ED, F, G.

• The balancing amount is long term capital gain.

SECTION 54EC

This section offers an exemption in the case of capital gains arising from the transfer of long-term assets. The exemption is available to all assesses, unlike the section 54 exemption (for gains arising from the transfer of a residential house where they are reinvested in another residential house) that’s available only to individuals and Hindu Undivided Families.

To avail of section 54EC exemption, you must invest your long-term capital gains (not the sale proceeds), either wholly or in part in a specified instrument, within six months of the transfer of the asset. The exemption is available to the extent of the gains invested or the cost of acquisition of the asset, whichever is less.

The salient features are:

Conditions: The following conditions should be satisfied:

1. Long term capital asset: A long term capital asset is transferred by an assessee (who may be an individual, firm, company or any other person) during the previous year.

2. Investment in “specified asset” – within six months from the date of transfer of the asset, the assessee should invest the whole (or any part of ) capital gain in the long term specified assets. “Long term specified assets” means any bond redeemable after 3 years issued—

1. By the National bank for agriculture and rural development or by the national highways authority of India;

2. By the rural electrification corporation Ltd; or

3. By the National Housing bank or by the small industries development bank of India.

Amount of exemption

The amount of exemption under section 54EC is as follows—

1. The amount of Capital gains generated on transfer of capital asset; or

2. The amount invested in specified assets as stated above, which ever is lower.

The cost of specified assets which is considered for the purpose of section 54EC shall not be eligible for tax rebate under section 88.

Example:

Mr. Verma sells the following long term assets on Jan 11, 2005-

Residential Gold Silver Diamonds

House

Property (Rs) (Rs) (Rs) (Rs)

Sale consideration 390000 810000 296000 640200

Indexed cost 70000 115000 178000 430000

Expenses on transfer 10000 81000 6000 32000

The due date of filing return of income for the assessment year 2005-06 is July 31, 2005. For claiming exemption under section 54 and 54EC, Mr. Verma purchases the following assets-

The amount of capital gain chargeable to tax for the assessment year 2005-06 :

Capital Gain Bonds

Investments in bonds issued by the National Bank for agriculture and rural development (NABARD), National Highway Authority of India (NHAI) and rural electrification corporation (REC) are at present eligible for capital gains tax savings. Gains made out of a transfer need to be invested in the above bonds within six months of sale capital assets in order for the proceeds of such sale to be exempt from capital gains tax. These bonds are available on an tap basis, i.e., continuously open for sale.

MINIMUM INVESTMENT: Minimum investment for NABARD Bonds is Rs 10000 or in multiples thereof and Rs 100000 for NHAI bonds. For REC, each bond has a face upper limit for investments in the above instruments.

INTEREST: In REC bonds, interest is paid @ 5%. An NHAI bond carries a coupon rate of 6.5%. interest is payable every year @ 5% (currently) in the case of NABARD Bonds.

MATURITY: The maturity of bonds is at the expiry of 7 years in case of NHAI, with a lock in period of 3 years as specified under section 54EC of the Income Tax Act, 1961. Similarly, NABARD/REC bonds are for 5 years and have lock in period of 3 years from the date of allotment of the bonds.

PREMATURE WITHDRAWL: NABARD/REC cannot be traded in the secondary market. While both these bonds have a lock in period of 3 years, NHAI bonds have a call and put option after 3 years.

LOAN FACILITY: NABARD/NHAI bonds cannot be offered as security for any loan or advance. This because instruments under section 54EC of the Income Tax Act, 1961, cannot be offered as security for a loan.

CREDIT QUALITY: The bonds are rated AAA by credit rating agencies, denoting maximum safety on your investment.

DETERMINATION OF MARKET VALUE OF NABARD/NHAI BONDS: The market value of the instrument is determined by the interest rate fixed for the instrument and the financial status of the issuing entity at the point of time.

TAX IMPLICATIONS:

The main feature of the NABARD/NHAI bonds is that you can claim Capital Gains Tax benefits benefit under section 54EC of the Income Tax Act, 1961. If you have realised any long term capital gains, you can avoid paying tax on it by investing the gains in the NABARD and NHAI bonds. Such gains have to be invested within 6 months of realising the same and the investment has to be locked for a minimum period of 3 years. However, the interest will accrue on this investment is taxable.

Note from Principal : Only REC and NHAI are now allowed to issue such bonds in the Current financial year of 2007-08.