Section 112A of Income Tax Act: LTCG Exemption

Section 112A of the Income Tax Act governs the taxation of long-term capital gains (LTCG) arising from the sale of listed equity shares, equity-oriented mutual funds, and units of business trusts. The recent changes introduced in the Union Budget 2024 have brought significant amendments to this section, impacting investors and taxpayers. Understanding these provisions is crucial for individuals and businesses engaged in stock market investments, as they directly affect tax liabilities and financial planning.

Key Changes in Budget 2024

The amendments in Budget 2024 have made notable changes to the LTCG tax framework under Section 112A, including an increase in tax rates and an enhanced exemption threshold. These revisions aim to optimise tax revenue while maintaining incentives for long-term equity investments.

Increased tax rate: The LTCG tax rate under Section 112A has been raised from 10% to 12.5%. This increase means investors earning significant capital gains from listed securities will now pay a higher tax compared to previous years.
Higher exemption limit: The exemption threshold for LTCG has increased from ₹1 lakh to ₹1.25 lakh. Investors with capital gains below this threshold continue to benefit from tax exemptions.
Effective date: These changes apply to securities sold on or after July 23, 2024, meaning transactions before this date follow the earlier tax provisions.

Applicability of Section 112A

The tax provisions under Section 112A apply under specific conditions. Investors must ensure that their transactions meet the eligibility criteria to qualify for the concessional tax rate.

The sale must involve equity shares, equity-oriented mutual fund units, or units of a business trust.
The securities must be classified as long-term capital assets, meaning they are held for more than one year before sale.
The capital gain must exceed ₹1.25 lakh from FY 2024-25 onwards to be taxable.
The purchase and sale of equity shares must be subject to Securities Transaction Tax (STT). Similarly, the sale of equity-oriented mutual fund units or business trust units must also be subject to STT.

Grandfathering Provisions under Section 112A

To protect investors from an abrupt tax liability on gains accrued before the introduction of Section 112A, the government implemented a grandfathering provision. According to this clause, gains earned up to January 31, 2018, are not subject to tax. The cost of acquisition for assets purchased before this date is adjusted based on the higher of:

The actual purchase price of the asset, or
The fair market value (FMV) of the asset as of January 31, 2018.

This ensures that only capital gains accrued after January 31, 2018, are taxed under Section 112A.

Scope and Important Provisions

For investors to benefit from the concessional LTCG tax rate, they must adhere to the following conditions:

STT payment on transactions: STT must be paid at both the acquisition and transfer of equity shares. For mutual funds and business trusts, STT must be paid at the time of sale.
Classification as long-term investment: Securities should be held as long-term capital assets and not as stock-in-trade. This means traders dealing in stocks as a business cannot claim the benefits of Section 112A.
No deductions allowed: Deductions under Chapter VI-A and rebates under Section 87A cannot be claimed against LTCG taxable under Section 112A. This provision ensures that tax benefits under other sections do not reduce LTCG tax liabilities.

Before and After the Amendment of Section 112A

The taxation of LTCG has evolved over the years, with major changes introduced in 2018 and again in 2024. Understanding this historical context helps taxpayers appreciate the impact of the latest amendments.

Before April 1, 2018: Long-term capital gains on listed equity shares and equity-oriented mutual funds were fully exempt under Section 10(38) if STT was paid.
After April 1, 2018: Section 10(38) was abolished, and Section 112A was introduced to tax LTCG exceeding ₹ 1 lakh at 10%.
After July 23, 2024: The LTCG tax rate has increased to 12.5%, and the exemption threshold has been raised to ₹ 1.25 lakh.

Exceptions to Section 112A

Certain categories of taxpayers and transactions are either taxed under different provisions or exempted from Section 112A:

Non-Equity Mutual Funds: Gains from debt mutual funds and hybrid funds are taxed under different provisions, typically under Section 112.
NRIs: Non-resident Indians (NRIs) are taxed under Section 115AD instead of Section 112A, which governs taxation for foreign investors.
IFSC Transactions: Securities listed in International Financial Services Centres (IFSCs) are exempt since they are not subject to STT.
Foreign Institutional Investors (FIIs): Gains from securities held by FIIs as capital assets are not covered under Section 112A.
Business Stock: If an investor proves that securities were held as stock-in-trade rather than capital assets, Section 112A does not apply.

Examples for Better Understanding

To clarify the implications of Section 112A, consider the following scenarios:

Example 1: LTCG Below Exemption Limit

Mr. X buys 1,000 shares of ABC Ltd. at ₹100 per share on March 1, 2024. He sells them at ₹180 per share on April 1, 2026.

Total Sale Price: ₹ 1,80,000
Cost of Acquisition: ₹ 1,00,000
LTCG: ₹ 80,000 (Exempt since it is below ₹ 1.25 lakh)

Example 2: LTCG Above Exemption Limit

Mr. A purchases 1,500 units of an equity-oriented mutual fund at ₹ 150 per unit and sells them after one year at ₹ 220 per unit.

Total Sale Price: ₹ 3,30,000
Cost of Acquisition: ₹ 2,25,000
LTCG: ₹ 1,05,000 (Exempt as per new ₹1.25 lakh limit)

Example 3: Applicability Based on Investment Nature

Mr. Z holds shares of XYZ Ltd. for over 3 years as a long-term investment and sells them at a profit of ₹ 1,00,000. Since these are capital assets, the gains qualify under Section 112A but remain tax-free as they are within the exemption limit.

Example 4: Taxable LTCG Scenario

Mrs B invests ₹ 5 lakh in equity shares and sells them after 2 years for ₹ 7.5 lakh.

LTCG: ₹ 2.5 lakh
Exempt Portion: ₹ 1.25 lakh
Taxable LTCG: ₹ 1.25 lakh
Tax Payable: 12.5% of ₹ 1.25 lakh = ₹ 15,625

Impact on Investors and Market

The revised tax rate may influence investor sentiment, especially among those relying on equity markets for wealth creation. Key implications include:

Retail investors: Higher taxation may encourage more strategic investment planning and diversification into other asset classes.
Mutual fund industry: Equity-oriented funds may see changes in investor preferences, with some shifting towards tax-efficient alternatives.
High-Net-Worth Individuals (HNIs): Investors with large equity holdings may need to optimise capital gains harvesting strategies.

Conclusion

Section 112A plays a crucial role in determining the tax liability on long-term capital gains from listed equity shares, equity-oriented mutual funds, and business trusts. With the recent changes in Budget 2024, investors should be aware of the higher tax rate and increased exemption limit to plan their investments efficiently. Proper tax planning and understanding of the eligibility criteria can help investors minimise tax burdens while making informed financial decisions.