Does Capital Gain when Indexation is Lost?

Inflation is a silent, ecumenical tax which robs the purchasing power of all citizens while inflating costs. It has bought down governments and destroyed economies the world over. Protecting citizens from the ravages of inflation is a stated if not primary objective of central bankers and governments across the world.

History of Cost Inflation Index and Capital Gains Taxation in India

To protect against inflation, the Indian Government introduced the Cost Inflation Index (CII), which is derived as 75% of the average increase in the urban Cost Price Index for the previous year. Indexation was a process by which the purchasing power existing at the point of acquisition of an asset was increased to match its current purchasing power as of today, thereby normalising the effect of inflation while calculating longterm capital gains (LTCG). Other sources of income were not provided indexation benefits as they were not ravaged by the long-term effects of inflation.

Taxation is on revenue, not on capital. Capital Gains is unique as it’s a tax on capital receipts. India’s tryst with LTCG taxation began in FY 1946-47 to curb the speculative investments in the high inflationary environment of post WW2. It was removed in 2 years, but reintroduced in 1956 basis the recommendation of Prof. Nicholas Kaldor. Since then, it has been constantly tweaked to balance out incentivising investments while augmenting government revenues. The concept of Indexation came out in the Chelliah Committee report, which was released in 1991-1992, wherein the erosion of purchasing power due to inflation was clearly highlighted. This resulted in the introduction of Section 48 of the Income Tax Act, 1961 which provided for the CII.

Thus, the removal of indexation, a shield against the ravages of inflation, has left a sore taste in the mouths of Indian taxpayers. But this removal comes in the wake of a 37.5% reduction in the LTCG tax rate from 20% to 12.5%. But the balance of this requires greater examination

Analysis of CII Removal vs the Change in LTCG Tax Rates

A comparison of the old vs new LTCG tax regimes shows that gains made in excess of 11% CAGR on average over a 24 year period makes the new regime more beneficial. This will change depending on the holding period. The average inflation as per CPI is 4.99% from April 1,2014 to April 1, 2024.

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The chart shows the ROI (return on investment) against the Holding period of the asset. The cells reflect the Rate of Return (CAGR) of the assets being sold. The colours indicate the scheme which is more beneficial for the tax payer. Yellow indicates that the older indexation regime is more beneficial while green indicates that the new, lower tax rate regime is more beneficial.

The question now is whether the median gains from various long-term asset classes is above or below the threshold of 11% CAGR. For the sake of ease of comparison, a common baseline period of 10 years (2014 to 2024) has been taken in the asset class analysis. But holding periods do affect the tax treatment and would need to be considered.

Interactive Dashboard for Scenarios

An interactive dashboard which showcases the breakeven point between the old vs new LTCG regime can be accessed here (LINK). The dashboard enables the following:

1.    Computation under the old and new LTCG regime

2.    Scenario analysis of the CAGR vs the multiples across both regimes

Impact on House Property Investments

House properties have long been incentivised by the government as a tax-advantageous investment avenue. Gains from any asset can be invested tax-free into housing property; principal amounts on home loans can be set off against 80C and interest can be set off against salary. Home loans have the lowest cost of funds for Indian individuals while 30% of rental income is exempt from tax. Housing has attracted lot of capital, but the industry has been struggling under the weight of unfinished projects for a longtime.

An analysis of the RBI’s All-India House PriceIndex (HPI) from its Database on Indian Economy shows that for a 10-year period, the average CAGR of housing prices in India grew at 3.78%. For housing investors to benefit from the new LTCG regime, they should have gotten a Rate of Return of over 10%, or an ROI of at least 2.5. None of the cities mentioned in the HPI boast of such returns.

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Impact on Gold Investors

Gold has been the preferred investment avenue for Indian households, along with FDs and real estate. An analysis of the average gold prices for 10grams between 2014 to 2024 shows a mere 9.92% CAGR. This is below the over 10% required for the new regime to be beneficial.

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Impact on Unlisted Equity Investors

Investors in unlisted equities in India always suffered the short end of the regulatory stick in India. Indian investors in unlisted equities suffered from a tax at the point of investment in the form of Angel Tax, which taxed investments (capital receipts) as income in the hands of the company, a uniquely Indian innovation for combating illicit funds; they suffered a holding period twice that of their listed counterparts and a tax rate that was at peak 2.48 times the rate of their listed counterparts, though this reduced to 2 times by 2023. This is why over 85% of the capital raised byIndian startups comes from overseas. Budget 2024 normalised this by removing Angel Tax and placing listed and unlisted equity LTCG taxation on par.

As unlisted security data is not published, a good proxy is the data submitted by SEBI Regulated AIFs for their SEBI mandated performance benchmarking exercise. The latest report as of September 30, 2023, by CRISIL for CAT I AIFs, which includes venture capital and angel funds, is given below.

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The average returns for this class for all funds from FY 14 to FY 23 is at 19.61%, much higher than the over 10% required for the new regime to be beneficial. Even a 40% discount for the professional management of AIF Managers places unlisted equity investors above the 11% threshold. While they may suffer due to the indexation benefits on losses being removed, Unlisted equity investors may be the largest beneficiary of the new LTCG regime.

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Asset Class Comparison

A comparison of asset classes versus the threshold rates shows that unlisted equities are best poised to benefit from the new LTCG regime.

But unlisted equity investors are a minority in the country and the revenue lost pales in comparison to the other asset classes. To ensure widespread benefit, the government should look at grandfathering the indexed value of all capital assets liable to indexation up to April 1, 2024. This is similar to the grandfathering done in 2018 when listed equity Long Term Capital Gains tax rate was increased to 10%, the government grandfathered the value up to January 31, 2018, as the cost of acquisition. This move will benefit a majority of taxpayers without materially affecting the government’s revenues. This is also in line with the government’s previous stance on such a matter. Budget 2024 memorandum also mentioned that a revision of the salary due to Partners under Section 40 of the Income Tax Act, 1961 was merited since the original limit was put in place in AY 2010-11. Timely revisions due to inflation are essential to maintain purchasing power.

The 5% inflation may not be as high as the inflation when the Chelliah Committee report was released, but it’s still a strong erosion of purchasing power. The effect on revenue loss will not be material, but it will vastly help India’s taxpayers.

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