From Exemption to Taxation: The Fall of Section 10(38) and Rise of 112A

Introduction

Section 10(38) of the Income Tax Act, 1961, once exempted long-term capital gains (LTCG) from the sale of equity shares and equity-oriented mutual funds, provided they were held for over 12 months and subject to Securities Transaction Tax (STT). Introduced in 2004 to boost stock market investment, it was abolished by the Finance Act, 2018, effective April 1, 2018, and replaced with Section 112A.

Reasons for Removal:

1)Revenue Loss

The exemption caused significant revenue loss to government as stock market gains grew, with high-net-worth individuals and institutions harvesting tax-free profits. This eroded the tax base, prompting the government to seek sustainable revenue sources.

2)Tax Inequity

Section 10(38) favored capital gains over taxable income sources like salaries or rent, disproportionately benefiting wealthy investors. This imbalance clashed with the principle of equitable taxation.

3)Tax Evasion and Abuse

The provision was exploited through fake transactions, such as circular trading and penny stock manipulation, to launder unaccounted money as exempt LTCG. Despite 2017 amendments mandating STT at acquisition and sale, loopholes persisted.

What the 2017 amendments did:

To tighten the rules and prevent misuse, the government amended the law in 2017 to mandate the payment of STT both at the time of acquisition (purchase) and sale of the shares or mutual fund units. Earlier, STT was mostly charged only on the sale side. This change was meant to ensure that only genuine transactions (where STT is paid both ways) would qualify for the exemption under Section 10(38).

Why loopholes persisted:

Despite this stricter requirement, some investors and entities found ways to exploit loopholes in the law by creating fake transactions that complied with STT requirements but were designed primarily to avoid paying taxes on capital gains. For example:

• Circular trading: Buying and selling shares among related parties or through multiple entities without genuine economic substance.

• Penny stock manipulation: Using low-value stocks to generate artificial gains exempted under Section 10(38).

What Replaced Section 10(38)?

With the removal of Section 10(38), the Finance Act, 2018 introduced Section 112A, which imposed a 12.5% tax on LTCG exceeding ₹1.25 lakh on the sale of:

1)Listed equity shares

2)Units of equity-oriented mutual funds

3)Units of a business trust

However, this tax applies only on gains exceeding ₹1.25 lakh, and the cost of acquisition for assets acquired before 1 February 2018 is grandfathered—i.e., the gains up to that date are protected from taxation.

Happy Readings,

With Best Regards

Uday Kumar Sahu

Mob: 9691857335