The direct tax code (DTC), which the government intends to apply from April 2011, contains large-scale changes with respect to capital gain taxation.

In the new regime, there will be no distinction between long-term and short-term gains as is practised currently. All capital gain income has to be aggregated with other income and taxed as per slab rates applicable to the taxpayer.

In other words, the current exemption for long-term capital gains on equity and equity mutual funds will stand eliminated. Even the concessional rate of 10/ 20% on non-equity long-term gains will no longer be applicable. On the positive side, the securities transaction tax will not be payable.

Though there is no distinction between long-term and short-term assets per se, in the case of a capital asset which is transferred anytime after one year from the end of the financial year in which it is acquired, the cost of acquisition will be adjusted on the basis of cost-inflation index.

This holding period of one year from the end of the FY is constant in all cases (even real estate) and not just for shares and mutual fund units.

The other notable difference in the holding period is that the Income-Tax Act, 1961 (ITA61) allowed indexation depending upon the period of holding on the basis of calendar dates.

In the DTC, indexation can be applied only if the holding period is one year from the end of the FY during which it was purchased. For example, for an equity share purchased in say, May 2011, for indexation to apply, it needs to be sold after March 2013 and not May 2012.

This also means that the advantage of double indexation where mutual fund schemes were launched -- such that the actual holding period was marginally over one year but overlapped two financial years -- will be history.

The base date for determining cost of acquisition under the DTC has been shifted to April 1, 2000, from April 1, 1981 under ITA61. The cost of acquisition is generally with reference to the value of the asset on the base date or, if the asset is acquired after such date, the cost at which the asset is acquired. As a result, all capital gains between April 1, 1981 and March 31, 2000 will not be liable to tax.

An example will illustrate this point better. For ease of understanding, indexation has been ignored. Suppose you have bought some shares on March 20, 1995 for Rs 60,000 and their value as on April 1, 2000 was Rs 1 lakh. Now if you sell these shares anytime on or after April 1, 2011 for say, Rs 2.5 lakh, your cost of acquisition for the purpose of indexation will be taken as Rs 1 lakh and not Rs 60,000.

Consequently, the gain of Rs 40,000 (Rs 1,00,000 - 60,000) from 1995 till 2000 escapes the tax net.

In the above example, the amount that will be taxable will be Rs 1.5 lakh (Rs 2.50 lakh sale price less Rs 1 lakh which is the value on the base date). It is possible to legally avoid even this tax by selling these shares a little before a April 1, 2011 (say, on March 25, 2011). Since the sale on March 25, 2011 will be governed by the provisions of ITA61, the entire long-term capital gains will be tax-free.

In fact, one can say with more than reasonable certainty that this is what exactly will happen -- when investors wake up to the reality that the blanket exemption on long-term capital gains tax is to be withdrawn, shares are going to be sold en masse. Such a fire sale is bound to eventually lead to a stock market crash. And since the change of law affects not only domestic retail investors but even FIIs, NRIs etc alike, this crash could well go on to be the mother of all crashes. Since such a situation is undesirable for investors and the government, preventive measures need to be thought of from now.

Possibly applying the new regime prospectively for new purchases on or after April 1, 2011 could be a solution.

Moving on, capital losses are to be ring-fenced under the DTC. This means capital losses will be allowed to be set-off only against capital gains. The unabsorbed capital loss can be carried forward for future set-off for any number of years as against a maximum period of eight years under ITA61.

Coming to deductions from capital gains, the current deduction under Section 54EC, where the capital gain amount may be invested in bonds for claiming tax exemption stands cancelled under the DTC.

The only tax deduction allowed is if the net sale proceeds of an asset held for over one year from the end of the FY in which it was purchased is:
a) reinvested for purchase or construction of a residential property either within one year before the beginning of the FY or during the FY in which the transfer of original investment asset is effected;

b) deposited in an account in any post office in accordance with the capital gains deposit scheme (CGDS) framed by the central government in this behalf within 60 days of the sale;

c) If the amount reinvested is less than the capital gains, proportional deduction will be available. If it is more, only the amount of capital gain is deductible.
The amount deposited in the CGDS has to be utilised for the purposes of purchase or construction of the new asset within three years from the end of the FY in which the transfer of the original asset is affected. This deduction is somewhat on the lines of the Section 54F deduction in ITA61.

However, under DTC, the deduction shall be allowed only if the taxpayer does not own any residential house, other than the new asset, on the date of transfer of the original asset. This means home owners will not be able save their capital gain tax.

This stipulation is extremely harsh and basically punishes someone for owning a roof over his head. It is hoped that before the draft becomes law, ownership of one house on the lines of Section 54F is allowed.

To sum
All considered, the harshest blow of the DTC seems to be the taxation of hitherto exempt long-term capital gains. In most cases, the jump would be from a zero tax regime to paying tax @ 30%.

Currently, one of the key attractions of our country is a tax-friendly capital market system. If this is taken away, there is no saying the extent of collateral damage that will take place.

Possibly reinstating the STT and taxing short-term gains at a flat rate of 30% while exempting gains for holding over one year would not only encourage long-term investing but would also augur well for the health of our market and economy.