Cost indexation while computing capital gain from transfer of assets received as gift etc.| CA Prakash Hegde and CA Raghavendra N.
Cost indexation while computing capital gain from transfer of assets received as gift etc.
By- CA Prakash Hegde and CA Raghavendra N.
The Income Tax Act, 1961 (‘the Act’) contains elaborate provisions in relation to taxation of profits or gains arising from ‘transfer’ of a ‘capital asset’. The relevant provisions for the purpose of our discussion are summarized below.
Relevant provisions of the Act
Section 45 provides that any profits or gains arising from the transfer of a capital asset shall be deemed to be the income of the previous year in which the transfer took place.
In this regard, section 2(14) of the Act defines a ‘capital asset’ to mean property of any kind held by an assessee. Certain assets like stock in trade, personal effects, agricultural land etc. are excluded from the purview of the definition.
Section 2(47) defines ‘transfer’, in relation to a capital asset, to include sale, exchange, etc.
Sections 2(42A) defines ‘short term capital asset’ to mean a capital asset held by an assessee for not more than 36 months (with certain exceptions). Explanation 1(i)(b) to section 2(42A) provides that, in determining the period for which any capital asset is held by the assessee in the case of a capital asset which becomes the property of the assessee, in the circumstances mentioned in section 49(1), the period for which the asset was held by the previous owner shall be included.
Further, sections 2(29A) and 2(29B) define ‘long term capital asset’ and ‘long term capital gain’ respectively.
Section 47 states that transactions like transfer of capital asset under gift, will etc. or on partition of a Hindu Undivided Family or by a company to its subsidiary company or by a subsidiary company to the holding company or by amalgamating company to the amalgamated company or by demerged company to the resulting company etc. are not to be regarded as ‘transfer’ for the purposes of section 45.
It is important to note that section 48 of the Act which provides for the mode of computation of capital gains allows certain deductions from the consideration viz. expenditure in connection with transfer, cost of acquisition of the asset and cost of improvement. The second proviso states that where long term capital gain arises from transfer of a long term capital asset, ‘cost of acquisition’ and ‘cost of improvement’ refer to ‘indexed cost of acquisition’ and ‘indexed cost of any improvement’ (except in cases stipulated).
Explanation (iii) and (iv) to section 48 define ‘indexed cost of acquisition’ and ‘indexed cost of any improvement’ respectively. “Indexed cost of acquisition” means an amount which bears to the cost of acquisition the same proportion as Cost Inflation Index (‘CII’) for the year in which the asset is transferred bears to the CII for the first year in which the asset was held by the assessee or for the year beginning on the 1st day of April 1981, whichever is later. “Indexed cost of any improvement” means an amount which bears to the cost of improvement the same proportion as CII for the year in which the asset is transferred bears to the CII for the year in which the improvement to the asset took place.
Lastly, section 49 of the Act provides that where the asset is acquired by the assessee under any of the specified modes (e.g. gift, will, inheritance, distribution of assets on liquidation of a company, transfer by subsidiary company / holding company, in a scheme of amalgamation from the amalgamating company etc.) cost of acquisition to the assessee shall be deemed to be the cost for which the previous owner acquired it.
Issue of controversy
Where an assessee acquires an asset in one of the specified modes e.g. by gift, will etc. and transfers the same, the following aspects will have to be considered for the purpose of computation of capital gain.
“Cost of acquisition” – This amount is the cost at which the previous owner acquired it (i.e. in the year of acquisition).
“Indexed cost of acquisition” – This amount is the amount of cost of acquisition computed on the basis of the CII for the year in which the asset is transferred and the “first year in which the asset was held by the assessee”.
First year in which the asset was held by the assessee is generally understood to mean the year in which the present owner acquired it i.e. though the cost of acquisition is the amount paid by the previous owner, the year from which the indexation has to be computed is the year in which the present owner acquired it. This does not appear to be logical!
The above issue of controversy could be best understood with the help of an example.
Let’s say, Mr A acquired a piece of land during the financial year (‘FY’) 1990-91 for a sum of Rs 100,000. During the FY 2000-01, he gifts this piece of land to his son Mr X who sells this land in the FY 2016-17, for Rs 10,00,000.
The CII for the above FYs are as below:
FY 1990-91 – 182
FY 2000-01 – 406
FY 2016-17 – 1125
As per section 49 and Explanation (iii) to section 48, indexed cost of acquisition in relation to the capital asset sold i.e. the piece of land has to be calculated by considering the CII for the “first year in which the asset is held by the assessee”. In this regard, the matter of dispute has been whether to consider FY 1990-91 or FY 2000-01 for the purpose of arriving at the indexed cost of acquisition.
If FY 1990-91 is considered as the “first year”, the amount of capital gain would be:
Rs 10,00,000 – Rs (1,00,000 / 182 *1125) = Rs 10,00,000 – Rs 6,18, 132 = Rs 3,81,868.
On the other hand, where FY 2000-01 is considered as the “first year”, the amount of capital gain would be:
Rs 10,00,000 – Rs (1,00,000 / 406 * 1125) = Rs 10,00,000 – 2,77,0935 = 7,22,906.
The assessees have been contending that based on the combined reading of section 49 and Explanation (iii) to section 48, it is more logical to consider the value and CII of FY 1990-91 in computing the indexed cost of acquisition for the purpose of arriving at the capital gain. However, this has not been accepted by the tax authorities who have been contending that there is no scope for a different interpretation as the language used in Explanation (iii) to section 48 is unambiguous and very explicitly states that the CII for the “first year in which the asset was held by the assessee” has to be considered for the purpose of computation of indexed cost of acquisition. Therefore, CII for FY 2000-01 has to be applied.
Judicial Precedents
The Mumbai Bench of the Income Tax Appellate Tribunal, in the case of Dy. CIT Vs Kishore Kanungo [2006] 102 ITD 437, had decided the above issue in favour of the income tax department. However, the Bombay High Court in CIT Vs Manjula J. Shah [2012] 204 Taxman 691 has set this issue to rest by deciding in favour of the assessee. The High Court ruled that,
“As rightly contended by the assessee, the indexed cost of acquisition has to be determined with reference to the cost inflation index for the first year in which the capital asset was ‘held by the assessee’. Since the expression ‘held by the assessee’ is not defined under section 48, that expression has to be understood as defined under section 2. Explanation 1(i)(b ) to section 2(42A) provides that in determining the period for which an asset is held by an assessee under a gift, the period for which the said asset was held by the previous owner shall be included. As the previous owner held the capital asset from FY 1990-91[1], as per Explanation 1(i)(b ) to section 2(42A), the assessee is deemed to have held the capital asset from FY 1990-91. By reason of the deemed holding of the asset from FY 1990-91, the assessee is deemed to have held the asset as a long term capital asset. If the long term capital gains liability has to be computed under section 48 by treating that the assessee held the capital asset from FY 1990-91, then, naturally in determining the indexed cost of acquisition under section 48, the assessee must be treated to have held the asset from FY 1990-91 and accordingly, the cost inflation index for 1990-91 would be applicable in determining the indexed cost of acquisition.
The above view has been subsequently endorsed by the Delhi High Court in the case of Arun Shungloo Trust Vs CIT [2012] 205 Taxman 456.
Further, the Karnataka High Court in the case of CIT Vs Smt. Asha Machaiah [2014] 227 Taxman 155 has also endorsed the above view by holding as under.
Though in the definition of ‘indexed cost of acquisition’, the words used are, “in which the asset was held by the assessee”, a harmonious reading of Sections 48 and 49 makes it clear for the purpose of ‘Indexed Cost of Acquisition’, it has to be understood as the first year in which the previous owner held the said property. Otherwise, if the date of inheritance is taken into consideration, then the cost of acquisition of the asset on that date corresponding to the market value is to be taken into consideration. Otherwise, take the cost of acquisition on the day the previous owner acquired it and apply the “Indexed Cost of Acquisition” and then calculate the capital gains and the tax payable. That is precisely what has been held by the Bombay High Court in the aforesaid Judgment which in our view is the correct legal decision.
Conclusion
The intention of the legislature in providing the indexation benefit has been very well explained by the High Courts and thus the controversy relating to the “first year in which the asset was held by the assessee” where the capital asset is acquired by the assessee in any of the modes specified under section 49(1) of the Act has been put to rest. Based on the above decisions, the assessee should consider the CII of the year in which the previous owner acquired the asset for the purpose of computation of capital gain in case the asset was acquired by him by way of gift, will, inheritance, distribution of assets on liquidation of a company, transfer by subsidiary company / holding company, in a scheme of amalgamation from the amalgamating company etc.
[1] Year changed to suit the example given supra