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Understanding Capital Gains Tax on Shares
Capital gains from shares are classified into short-term and long-term based on the holding period. If equity shares are sold within 12 months of purchase, any profit earned is considered a short-term capital gain (STCG) and is taxed at a flat rate of 20% under Section 111A of the Income Tax Act. However, if shares are held for more than 12 months, the profit qualifies as a long-term capital gain (LTCG). LTCG on equity shares is tax-free up to ₹1 lakh, but any amount exceeding this limit is taxed at 12.50% without the benefit of indexation.
One of the biggest advantages for long-term investors is the tax exemption on LTCG up to ₹1.25 lakh in a financial year. This means that an investor can earn tax-free capital gains if the total LTCG remains within this threshold. For example, if an individual sells shares and makes a long-term profit of ₹90,000 in a year, they do not have to pay any tax. However, if the gains exceed ₹1.25 lakh, the additional amount is taxed at 12.5%. This provision encourages long-term investing and allows individuals to optimize their tax liabilities.
For unlisted shares, the government allows an indexation benefit, which adjusts the purchase price based on inflation before calculating capital gains tax. This helps reduce taxable profits, lowering the overall tax liability. Indexation takes into account the Cost Inflation Index (CII), which factors in inflation over time. For instance, if an investor buys unlisted shares for ₹5 lakh and sells them after 5 years at ₹10 lakh, the indexed purchase price may be adjusted to ₹7 lakh, reducing taxable gains to ₹3 lakh instead of ₹5 lakh. This benefit applies only to LTCG on unlisted shares.
Investors can minimize their tax liability by setting off capital losses against capital gains. Short-term capital losses (STCL) can be adjusted against both STCG and LTCG, while long-term capital losses (LTCL) can only be set off against LTCG. Additionally, if capital losses cannot be fully utilized in a financial year, they can be carried forward for up to eight years. This means that if an investor incurs a loss of ₹2 lakh in one year and has gains of ₹3 lakh in the following year, they can offset the previous losses and pay tax only on ₹1 lakh of gains.
Investors often receive returns from shares in two ways—through dividends and capital gains. Dividends are taxed as per the individual’s income tax slab, which can go up to 30% for high-income earners. In contrast, capital gains tax is lower—LTCG is taxed at 12.5% (above ₹1 lakh), and STCG at 20%. This makes capital gains a more tax-efficient way to earn from stock investments. Strategic investors prefer selling shares for capital appreciation rather than relying solely on dividends to minimize their tax liability. Understanding these differences helps investors make informed financial decisions.
The Union Budget of February 2025 introduced several key changes to the capital gains tax framework in India, effective from April 1, 2026. Here’s an overview:
1. Revised Long-Term Capital Gains (LTCG) Tax Rates:
Increased Tax Rate: The LTCG tax rate on listed equity shares and equity-oriented mutual funds has been increased from 10% to 12.5%. The exemption limit for LTCG remains at ₹1 lakh, meaning gains up to this amount are tax-free; gains exceeding ₹1 lakh are taxed at the new rate.
2. Uniform Taxation for Foreign Institutional Investors (FIIs):
Aligned Tax Rates: To establish parity between domestic and foreign investors, the LTCG tax rate for FIIs on securities has been increased from 10% to 12.5%. This change ensures that both resident and non-resident investors are subject to the same tax rate on long-term capital gains.
3. Taxation of Unit Linked Insurance Plans (ULIPs):
New Tax Implications: ULIPs with annual premiums exceeding ₹2.5 lakh will now attract an LTCG tax rate of 12.5%. This amendment aims to harmonize the tax treatment of ULIPs with that of equity mutual funds, ensuring consistency across investment products.
4. Adjustments for Alternative Investment Funds (AIFs):
Standardized Tax Rates: The LTCG tax rate for Category III AIFs has been increased to 12.5%, aligning it with the rates applicable to other investors. This change is part of the government’s effort to simplify and standardize the capital gains tax structure across various investment vehicles.
5. Extension of Tax Exemptions for Sovereign Wealth and Pension Funds:
Extended Investment Deadline: The deadline for investments by sovereign wealth funds and pension funds to avail tax exemptions has been extended to March 31, 2030. This extension provides these funds with a longer window to invest in specified infrastructure projects while benefiting from tax exemptions.
6. Clarification on Securities Held by AIFs:
Capital Asset Classification: Securities held by Category I and II AIFs will be treated as capital assets, and any income arising from their transfer will be taxed under the head of capital gains. This amendment provides clarity on the tax treatment of income from securities held by these funds.
7. Changes to Tax Deducted at Source (TDS):
Reduced TDS Rates: The TDS rates for various payments, including insurance commissions, interest on securities, and dividend income, have been reduced. For instance, the TDS rate on insurance commission has been decreased from 5% to 2%, aiming to simplify compliance and improve cash flow for recipients.
These amendments reflect the government’s commitment to streamlining the tax system, promoting equitable treatment among investors, and encouraging long-term investments in the Indian economy.