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Before I delve into my topic of discussion, let me give a short brief about section 54F of the Income Tax Act 1961.

Section 54F deals with exemptions from capital gains, it provides that in case of an individual or a HUF, capital gains arising from the transfer of a long term capital asset not being a residential house shall be exempt if the entire sale consideration for such transfer is invested in a residential house. The section also provides the method of calculation of exemption if only a part of the sale consideration is so invested. For a further understanding of the provisions please refer to the said section.

Now to understand the effects of this provision, consider the following practical case:-

Mr. X an industrialist has a flourishing business of manufacture of a certain article. In addition he has a commercial property consisting of a factory shed and appurtenant land thereto, which he had purchased many years back at a very good price. The property now can be valued at many times the actual cost of acquisition of the property.

Now Mr. X desires to sell the property and so he starts the search for a suitable buyer. The deal is struck and Mr. X fetches a very good price for the property.

The capital gains as computed in accordance with the provisions of the Income Tax Act 1961 works out to be an amount running in many crores. Now Mr. X approaches his CA to seek advice on how to reduce the incidence of capital gains tax. As any rational person would do , the CA advices Mr. X to invest the entire sale consideration in a residential house and thereby avoiding tax liability vide provisions of section 54F of the Act. According to the CA’s advice Mr. X invested the same in a residential property.

Lets analyze the situation:-

1. For the sake of calculations lets assume that the sale consideration of the commercial property is Rs. 10 Crores.

2. Now if Mr. X would have invested the amount in his current business he would have used the money for a productive purpose and would earn additional income due to the investment. Lets assume a return on investment (ROI) of 10%(which is reasonable in a SME manufacturing unit). So an additional income of Rs 1 Crore would have been earned on the said Rs 10 Crores.

3. From this money Rs 30.9 Lakhs (i.e 30.9% of Rs. 1 Crore) of Income Tax would have been the revenue of the Govt. which could be used for development activities of the Govt. which would prove to be beneficial to the economy as a whole.

4. The remaining Rs. 69.1 lakhs would either be reinvested in the business and would generate additional funds or would have been spent for consumption expenditure or would be invested in savings instruments like bank FDR or the stock market or mutual funds or Govt Bonds etc. What ever the mode of utilizing that money, it would prove to be beneficial to the economy as a whole as the money instead of being idol would have been mobilized (the multiplier effect).

5. But instead of the Rs 10 Crores being utilized for productive purposes it was invested in a residential house which can be termed as a “dead investment”.

6. Now Mr. X can do two things with the residential property:-

a. Leave it as an idol investment or

b. Rent out the house and earn rental income from it or

c. Sell the house.

Option ( c ) is not feasible as the provisions of section 54F requires the house to be held for atleast 3 years otherwise the exempted CG would be subject to tax.

That leaves out only options ( a ) or ( b ).

If option (a) is selected:-

1. No additional funds would be generated from the property at all and the same would be an unproductive asset.

2. If Mr. X owns 1 house other than the new house he would be subjected to wealth tax under the provisions of the Wealth Tax Act 1957.

3. As Mr. X is a businessman and assuming that the business is the only source of his income he would have to pay the wealth tax from the income earned out of business and thus depleting productive funds of Mr. X

4. From the Govt. point of view the wealth tax revenue would be substantially lower than the income tax which would have been received had the money been put to productive use as discussed earlier.

If option (b) is selected:-

1. Now the asset would be productive.

2. It is a generally excepted norm that the annual rent for a residential house works out to be approximately 2.5% of the value of the house. In our case the rent would work out to Rs 25 Lakhs(2.5% of Rs 10 Crores).

3. The Income Tax liability on the rent would be worked out as under:-

GAV                                               Rs. 25 Lakhs

Less:- Municiple Taxes                 Rs.  1 Lakhs(say)

NAV                                               Rs. 24 Lakhs

Less: 30% Std deduction              Rs. 7.2 Lakhs

                                                      Rs. 16.8 Lakhs

Tax @ 30.9%                                Rs. 5.19 Lakhs

*assuming highest slab rate

4. Thus it can clearly be seen from above that by not investing in business and investing in the house and renting the same leads to a substantial revenue loss to the Govt and also to Mr. X and most importantly to the economy as a whole.

The very purpose of wealth tax is to avoid idol unproductive assets but it is a paradox that provisions like section 54F help in creating such assets in the first place.

Now some might argue that this provision gives a boost to the residential construction sector and thus is beneficial to the economy. While I don’t disagree with that view point, I am of the opinion that giving boost to one sector on the cost of reducing the flow of fast moving funds in the economy is not a desirable course of action.

CA Mikdad .S. Merchant

Published by

Mikdad Merchant
(Chartered Accountant)
Category Taxpayers   Report

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