Bootstrapping ---- Procedures to improve capital gains tax collectiion
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Proposed administrative procedure - TX.02
Improving   capital-gains   tax   collection  

  1. Capital gains tax on sale of lands/flats
  2. Capital gains tax on sale of construction
  3. Partioning of portfolios
  4. Capital gains tax on gold etc
  5. Capital gains tax on sale of shares
  6. Draft of the act to create procedure TX.01

Proposal - TX.02.0001 - Improving collection of capital gains tax on sale of lands/flats

Problem : Say today's date is 1/1/2003. Say a person had bought a flat seven or more years ago, say in year 1996 or earlier, for a price of Rs 10,00,000/- and and he sells it today for Rs 20,00,000. Now the indexed purchase price is (Index of year 2003)/(Index of year 1996)*(purchase price) = 447/281 * 10,00,000 = 1.59 * 10,00,000 = Rs 15,90,000 or say 16,00,000 as a round figure. hence capital gains is Rs 20,00,000 - Rs 16,00,000 = Rs 400,000. And tax due will be 20% of that i.e. Rs 80000.

How do may people save this tax? By buying another flat in next 1 year, or buying certain bonds (like RBI bonds). That is NOT an evasion.

But what the seller can say that he had done a maintainace work on the flat (called as alteration) worth say Rs 300,000. Hence the index price of the flat now become larger than Rs 20,00,000. Proof that he had done an alteration? Since the work was done over 6 years go, no proof is needed !!! And if scrutiny comes, the ITO can at most make accessee's life dificult by raising querries, but cant do anything legally to force him to pay the tax due on him.

What is worse is following : not only the seller can evade the taxes, he can claim a capital loss, and evade the capital gains tax due on some other item. How?

Say a person X owns a house he had purchased in year 1996 for Rs 10,00,000 and sells it in 2003 for Rs 20,00,000. The indexed price would be around Rs 16,00,000 and so capital gain is Rs 400,000 and capital gains tax would be Rs 80000. Also, say same person has sold a house he had bought in year 2000 for Rs 10,00,000 and he sells it for Rs 15,00,000 in year 2003. The indexed price of second house will be (Index2003/Index2000)*10,00,000=(447/389)*10,00,000 = 1.15*10,00,000 = 11,50,000/-. Now since the house was purchased less than 3 years before the sale date, it is NOT possible to show any fictitious alterations, and so it is difficult to evade capital gains tax on the second house. So capital gains on second house will be Rs 350,000 and so tax due will be Rs 70,000. So legally speaking, total capital gains tax is Rs 80000 + Rs 70000 = Rs 150,000. Now how can person "illegally" but still officially evade ALL the tax?

All he has to say is that he did alteration of Rs 500,000 in 1996 on first house. Proof? No proof needed, as the claim says that alteration was done over 6 years ago. And if the house was bought before base year i.e. 1981, the person can even say that house's valuation in 1981 was Rs 15,00,000, without any claim/proof what-so-ever. So indexed price of first house becomes = (447/281)*15,00,000 = 23,86,000/-. So there is capital LOSS of Rs 23,86,000 - Rs 20,00,000 = Rs 386,000 on the first house. So total capital gains from first house and second house is a net loss of Rs 36000, and hence no tax is due.

What is equally bad is following : Say a person is running a business, and using his flat as office. Say the flat was bought in 1991 for Rs 10,00,000. Now say every year alteration of Rs 50000 were made as furniture repairs or buying/repaing electrical equipment etc. Now the person can easily take these as business expeses and deduct it from his gross income. He he takes an alteration as business expense, as per the law, he is NOT allowed to add it as capital expense. But say he sells the flat in year 2003. Then it is trivially easy for him to add ALL alterations expenses from year 1991 to year 1996 as capital costs, and claim a higher indexed puchase price.

IOW, the capital gains tax is OPENLY evaded as the accesse is NOT required to show the alterations he makes EVERY year. The proceure I propose, namely TX.02.0001 makes it compulsory to show alterations done every year, and thus reduces evasion of capital gains on flat etc.

Solution : procedure TX.02.0001

All individuals who meet ANY of the following criteria
  1. with gross income above Rs 10,00,000 in any of the past 3 years
  2. who have FDs above Rs 10,00,000 and are below 55 years
  3. who own more than 5 flats/plots/offices/shops
  4. who owns more than 2 cars in his own name
  5. who are directors in ANY pvt or public limited company
  6. is a trustee of any trust with wealth above Rs 1 crore
  7. sitting MLAs, MPs or Ministers
  8. sitting judges in court/tribunal
should be required to file house/land ownership return for EVERY house/plot they own partly or wholly. As time goes, the list stated above should be expanded so that almost all house/flat owners are filing an assset statement.

If return filing person buys house AFTER passing of this law, following procedures will apply :
  1. Every year person will have to file a return showing the amount of capital additions (alterations) he made on the house.

  2. The new value of house will be computed as =
    (value of house in last to past year) * (Index of last year)/(Index of last to last year) + (capital additions made in last year).
    eg say house was bought on 1-Apr-2001 for Rs 10,00,000. Say index as on 31-Mar-2001 was 250 and index as on 31-Mar-2002 was say 270. And if alterations of worth Rs 50000 were done during 1-Apr-2001 to 31-Mar-2002. Then new value of house as on 31-Mar-2002 will be
    Rs 10,00,000 * 270/250 + 50,000 = Rs 11,30,000.
    The above will be the closing value of the house as on 31-3-2002 and will be the opening value as on 1-4-2002 for the next year.

  3. The above value will be the MAXIMUM value he may claim on the house. He may take a depreciation of upto x%, and show a lesser value, in which case capital gains will be higher in case he decides to sell the house later on. Why would one take a depreciation? Because the wealth tax will be computed on the value he states. So if a person takes full advantage of indexation and takes no depreciation, wealth tax will be higher.

How does the above procedure reduce evasion? Because the property owner has to show capital additions every year, in case he intends to take them into basic costs later on at the time of calculating capital gains. Hence, he MUST show an income in that year, or else some previous years, or else capital additions without income will prove an inconsistency. Now if the person does show an income, he will have to pay a tax on it. So basically, the procedure TX.02.0001 will ensure that a person will eighter NOT show fictitious capital additions, or he will end up paying income tax on it -- so in eighter case, the govt does NOT loose taxes.

The procedure TX.02.0001, coupled with procedure
TX.01.0005 reduces possibility of fictitious capital additions to near zero. Why? Becuase if a person states that he has made capital additions of say Rs 50,000/-, he will need to specify the tax-IDs of the individuals to whom he paid for those alterations. And the person whose IDs are mentioned will need to show it in their gross reciepts, and hence pay taxes on it. There will NO problem, if alterations were done in reality. But if no alterations were made, the owner will NOT be able to claim any alteration several years down the road.

TX.02.0001 fully solves the problem of properties that are bought AFTER the law enacting TX.02.0001 is passed. But what about flats etc bought BEFORE the law was passed? For those properties, the law will be as follows
  1. if the house was bought less than six years ago, the owner will have to file the date/price he had purchased, and alterations he made in each year, and thus net present indexed value as on 31/3/XXXX.
  2. if the house was bought before six years, the owner will have to file a return showing its total indexed value as on six years ago, and alterations made in past six years and net indexed value as on 31/3/XXXX.
And then onwards, if he has made any capital additions on the house, he will need to specify them in each annual return of that house.

Return filing in case there are several owners :

If a house has more than one owner, then in the first year, they must speciy the %-ownership of the house. All owners must unianimously agree, or else it will be considered a dispute and court will decide. After that year, if capital additions are done, it will be assumed that each owner has contributed to the capital additions in same ratio as ownership. If the percentage ownership changes, it would be considered as internal sale, and proportionate transfer tax as well as capital gains tax may apply, and a new return will have to filed.

eg say A and B buy a house worth Rs 10,00,000 and specify ownership as 20:80. Say no capital addition is done, and index 3 years from then rises by 30%. So indexed cost of house is Rs 13,00,000. Now say A and B decide to change ownership as 45:55. Then it would be considered as sale of 25% of property from B to A. They must specify the sale price if any, or it will be assumed as zero. If the sale price is specified say Rs 100,000, then basically 25% of the property of indexed cost Rs 13,00,000 * 25/100 = Rs 325000 will be deemed as sold by B to A for Rs 100,000. In such case, the index cost of A's 45% share will be
(10,00,000*20/100)*1.3 + 100000 = 260,000 + 100,000 = Rs 360,000
And value of 55% of B's share will be (10,00,000 * 55/100)*1.3 = 715000. And B may take a capital loss of (10,00,000 * 20/100)*1.3 - 100,000.

Proposal - TX.02.0002 - Improving collection of capital gains tax on sale of construction

Problem : Say a person buys a land in year say 1984 for say Rs 10,00,000/-. He builds a house worth say Rs 400,000 in year by the end of year 1984. So total cost is Rs 15,00,000 in 1984. Now several 20 years from then, say in year 2003, he sells the whole plot, land plus house for say Rs 60,00,000. Say no capital additions were done in that time. Now indexation in year 2003 wrt 1984 is say 400%. So index cost of house will be Rs 14,00,000 * 400% = Rs 56,00,000/-. So capital gains, as per today's laws, will be only Rs 400,000 and tax will be 20% of that i.e. say Rs 80,000.

What is the flaw?

In reality, the house's value has two parts --- value of land and value of construction. In above example, the land value was Rs 10,00,000/- and indexed cost of land was thus Rs 40,00,000/-. The cost of construction is Rs 400,000/-. But every construction undergoes depreciation of atleast 3% to 5% a year. Even if a MINIMAL depriciation of 3% a year is taken, the cost of construction in year 2004 was only Rs 218,000. and hence indexed value would Rs 218,000 * 4 = Rs 870,000. So the indexed cost of house plus land should be Rs 48,70,000. And thus capital gains is about Rs 11,30,000 and tax due would be around Rs 2,26,000.

IOW, a property owner should be required to show land cost and construction cost seperately, and should be required to take depreciation on construction which CANNOT be passed as expense if the property is NOT used for business (and if the property is used as business, no indexation would be allowed on it). This will improve capital gains collection, without any unfairness.

Proposal TX.02.0003 : Partioning of portfolios
  1. Capital gains will be classified into 4 categories : gains on houses/land, gold/silver and other precious metals, shares/bonds and equipment.

  2. Gains made in one category cannot be set-off against losses in another category.

  3. Example : Say a house is sold and there is a capital gains of Rs 100,000. And in the same year shares are sold and capital loss is Rs 60000. Today's laws allow a set-off or cancellation, and thus net capital gains is ONLY Rs 40,000. But the change I propose will NOT allow cancellation in this case. The person will have to pay capital gains tax on house, and he may carry forward capital loss on shares to the next year.

  4. eg2. However, if there is another house which is sold in the SAME year, and there is capital loss, it can be set-off against capital gains from sale of another house.

Proposal TX.02.0004 : Improving capital gains tax collection on gold etc sales

Problem : All individuals who meet ANY of the following criteria
  1. with gross income above Rs 10,00,000 in any of the past 3 years
  2. who have FDs above Rs 10,00,000 and are below 55 years
  3. who own more than 5 flats/plots/offices/shops or
  4. who owns more than 2 cars
  5. who have travelled abroad more than thrice in past 3 years
  6. who are directors in ANY pvt or public limited company
  7. is a trustee of any trust with wealth above Rs 1 crore
  8. sitting MLAs, MPs or Ministers
  9. sitting judges in any court/tribunal
should be required to file a gold, silver etc disclosure annual return, whether a wealth tax is due or not. Gradually, the list should be extended to include everyone who possesses any gold.

In the annual disclosure, they must report following items
  1. Gold, silver etc they have as on the start of financial year
  2. sale/purchases etc of gold, silver etc in that financial year, with dates and prices
  3. net gold, silver etc they have at the year-end.
  4. If unreported gold is later found or disclosed, it will be considered as income of last year, and tax at the rate of highest marginal rate would be applied, plus interest and penalty as applicable.
  5. The sale/purchase will be taken as "first bought first sold" basis.

The above steps would improve collection of capital gains taxes from gold.

Proposal TX.02.0005 : Improving capital gains tax on sale of shares

  1. The Income Tax Dept should instruct ALL companies to specify the tax-ID of ALL the shareholders. All Deemat account companies should be required to specify the tax-IDs and their holdings.

  2. All companies should be required to Deematize their shares. The non-deematized shares should be graudally voided.

  3. The companies should be required to report the transactions to Income Tax Dept with transaction number (as given by the exchange or broker), tax-IDs of buyers/sellers, and the daily high/low prices.

  4. Every broker/exchange should be required to report the transactions to Income Tax Dept with transaction number (as given by the exchange or broker), tax-IDs of buyer/seller and the sale price.

  5. The share buyer/sellers must exchange the amounts strictly by payee-ac checks, directly of via a registered broker.

  6. If a person intends to buy/sell shares, he must register himself with one or more brokers. The broker will be required to give an annual statement to its clients displaying
    1. the opening position as on year begining, which should be same as closing position as on the end of last year
    2. sales, purchases, loans with corresponding dates and prices
    3. cash added or taken out with dates
    4. transfers from other brokerage and purchase dates/prices as reported by him
    5. the closing positions
    6. net cash added or taken out in the year

  7. The broker will also send a copy to the income tax dept.

  8. The IT-dept can charge upto say Rs 10 per sale, purchase or transfer irrespective of amount involved from the broker. The broker may pass the charge on to client.
  9. The sharefolders will combine all the brokers' statements, and provide a consolidated statement showing consolidated opening positions showing individual scrip with different dates and purchase price, individual sales/purchases with dates and prices, individual cash added or taken out with dates, consolidated closing positions and consolidated net cash added or taken out. And based on this statement, the shareholder will calculate net capital gains based on "first bought first sold" basis.

  10. If a company has shut down, and shares are voided, the person can/must take the capital loss in that year itself. And in case the shares have become defunct, but company has NOT officially closed down, the person can transfer the shares to Income Tax dept, and claim the purchase value as capital losses in that year.

This will ensure that a person cannot hide his capital gains on shares.

Draft of the act to create procedure TX.02

There is NO one single draft to enact TX.02.

  1. To create ID-based reporting of expenses, the Parliament first needs to pass a draft that would ensure that every person indeed has an ID.

  2. To implement other proposals related to improving collection of capital gains taxes, a draft for each is needed in the Parliament. To see the drafts, pleae click here.
     Now citizens can ask MPs to pass these Acts. But IMO, it will be wiser for citizens to first enact procedure LM.03, and then use LM.03 to pass these drafts WITHOUT any help from MPs. To know about procedure LM.03, please click here .

If you have any other question, please mail it to Thousand thanks in advance.

Next - TX.03 : Procedures to improve wealth tax collection