[Analysis] Capital Gains Scheme Account – Why Deposits Won’t Reduce Taxes from 20% to 12.5%?

The Capital Gains Account Scheme (CGAS) is a tax-saving mechanism under the Income Tax Act, 1961, that allows taxpayers to defer capital gains tax when they plan to reinvest the proceeds from the sale of a capital asset but are unable to do so immediately. Taxpayers intending to claim deductions under Sections 54, 54B, 54D, 54F, or 54G can deposit their gains in a special account in a designated bank until they are ready to reinvest in specified assets, like a residential property. There are two types of accounts under this scheme: a savings deposit account (Type A) and a term deposit account (Type B). If the funds remain unutilised beyond the specified period, they are treated as long-term capital gains and taxed accordingly.

The recent Union Budget cast a veil of uncertainty, spawning theories about a potential tax arbitration advantage for transactions involving long-term capital assets transferred before 23rd July, 2024. One such speculative theory posits that by depositing the transaction proceeds into a capital gains account scheme and not using these funds within the statutory time frame; a taxpayer might reduce their tax rate from 20% to 12.5%. To unpack this, we should start with the fundamentals.

When a property held for over 24 months is sold on or before 22nd July, 2024, the seller can factor in the indexed cost of acquisition to calculate the long-term capital gains. This process, known as indexation, adjusts the acquisition cost to mitigate the effects of inflation over the period of ownership based on the annually notified Cost Inflation Index (CII). The resulting long-term capital gain is taxed at a rate of 20%.

This indexation benefit, stipulated under the second proviso to Section 48 of the tax code, and the corresponding tax rate, under Section 112, are set to undergo substantial revisions starting 23rd July, 2024. From this date, the indexation will no longer be permissible, and the tax rate will drop to 12.5%.

To understand the potential tax arbitration, it’s essential to grasp two more concepts:

1. Investment Rollover Deductions: Sections 54 through 54GB permit taxpayers to reduce their capital gains tax liability by reinvesting the proceeds into new assets within specified timelines. The most common deductions for reinvestment into residential properties are under Sections 54 and 54F.
2. Capital Gains Account Scheme: This scheme acts as a provisional solution for those intending to claim deductions under Sections 54 and 54F but unable to reinvest by the tax return filing deadline. By depositing the gains into this special account, a deduction is claimable. However, if the funds aren’t utilised within the designated timeframe to purchase a new home, they are deemed as long-term capital gains in the year the timeframe expires, presenting a theoretical opportunity for tax arbitration.

The dilemma arises around the taxation of these deemed gains. If the capital gains from an asset sold before 23rd July, 2024, are deposited and not reinvested by the expiration of the reinvestment period post-July 23, 2024, would the applicable tax rate be the lower 12.5%? Despite the new lower tax rate effective from 23rd July, 2024, two factors support that such deemed gains should still incur a 20% tax rate:

1. Deeming Provision: The tax is levied on these unutilised funds as capital gains due to a statutory fiction, not due to the actual transfer of an asset.
2. Budget Provisions: The 2024 budget’s reduced tax rate of 12.5% specifically applies to transfers occurring on or after 23rd July, 2024.

Thus, the reduced rate does not apply because the taxability stems from the cancellation of a prior year’s deduction under Sections 54 or 54F for a transfer that occurred before 23rd July, 2024.

To illustrate, consider Mr A, who bought a house for Rs. 25 lakhs in January 2016 and sold it for Rs. 1 crore on 1st August, 2022. He deposited Rs. 70 lakhs into the special account in July 2023 but failed to purchase a new house by the deadline of 31st July, 2025. His tax liability, triggered by the withdrawal of the deduction under Section 54, would be calculated using the CII for 2015-16 and 2022-23, which were 254 and 331, respectively.

It is advised to avoid asserting that the withdrawal of a deduction due to the non-utilisation of the deposit is taxable at 12.5% if the capital asset was transferred before 23rd July 2024. Making such a claim could lead the department to disallow it and impose a penalty for the misreporting of income.