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Ensure equity in taxing capital gains
January, 02nd 2007

Property sales in the over $12-billion real estate market has been brisk over the last two years or so. Scores of investors are cashing in on the boom in the realty market, which is growing at a scorching 30% and making tidy capital gains.

In the normal course, if an investor sells a capital asset say an immovable property after 36 months from the date of acquisition, the gains from such sale are treated as long-term capital gains and taxed at 20% with indexation benefits. He is exempt from paying tax if these gains are invested in select bonds, known as 54 EC bonds after a section in the Income Tax Act.

The benefit is available to other assesses as well including firms, companies and trusts.Obviously, there is a clamour to invest the gains from sale of property in such bonds to escape tax.

However, this fiscal, investors are a bit hamstrung as the government has restricted the issuance of 54 EC bonds to just two institutions Rural Electrification Corporation and the National Highways Authority of India (NHAI). This was not the case in 2005-06.Before April 1, 2006, the tax benefit could be claimed by investing in bonds floated by Nabard, Sidbi, NHB, besides NHAI and REC.

There were no restrictions on the amount that these institutions could raise from these bonds, which were meant to provide a focussed incentive for infrastructure investments. Investors parked around Rs 14,000 crore in 54 EC bonds in 2005-06.

However, the revenue implications coupled with the intention to phase out exemptions in the medium term prompted the government to allow just two institutions to raise funds through this route this fiscal.For the first time, it also placed a cap on the aggregate subscriptions. REC, which had initially sought an authorisation for around Rs 8,000 crore for its rural electrification projects, was allowed to raise Rs 4,500 crore in the first tranche. NHAI had a mandate to raise Rs 1,500 crore, taking the aggregate amount to Rs 6,000 crore. The move to restrict authorisation was also to ensure that these institutions do not sit on idle funds.
Although it was not explicitly stated, these bonds were practically available on a first-come-first-serve basis. However, investors had the flexibility to invest any amount in these bonds. Subscriptions closed by August, though there were several investors who missed the bus.

Meanwhile, the government got a feedback that the bonds were lapped up by a few big corporate groups and high networth individuals. So, last week, while authorising REC to raise another Rs 3,500 crore through this route, it tightened the norms for issuance.

The intention was to give the tax benefit to investors with a low-risk appetite, while containing it for those making big time capital gains.A limit of Rs 50 lakh has been fixed for each applicant. This means if a person has already invested more than Rs 50 lakhs, he will not be allotted any more bonds. However, if he has invested, say, Rs 35 lakh, he can invest another Rs 15 lakh in the second tranche of REC bonds.

The good news for investors is that the time limit has been extended those who have transferred capital assets between September 29, 2005 and September 30, 2006 can subscribe to these bonds. Is the mid-course correction justified? Policy managers reckon that since the Central Board of Direct Taxes (CBDT) has the power to notify these bonds, it can also tighten the norms to ensure vertical equity among tax payers. Some tax experts, however, disagree, saying that changes should be through amendments in the legislation.

But the fact remains that the real estate market is becoming speculative. Chairman, HDFC, Deepak Parekh, had talked about at least a quarter of the demand for real estate being driven by speculation in his statement in the annual report for 2005-06. According to him, this is an unhealthy trend and has led to unaffordable price levels in many cities.

While this particular tax incentive, Section 54 EC, is up for review with a host of other exemptions, a view that has emerged within the government is that scrapping this exemption in the near term will be not be fair to investors who are not big risk-takers. This segment could cover the middle-class or investors who do not invest in mutual funds or equities.

In case the government continues the incentive in the coming fiscal, one option could be to restrict the tax benefit to investors whose capital gains difference between sale price and cost of acquisition from sale of assets does not exceed, say, Rs 50 lakh or any limit prescribed by the government. This means investors who have capital gains above this limit will not be entitled to this benefit at all.

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