Managing a capital gains tax liability can be quite a handful for assessees. The conventional method of dealing with such a liability is to simply invest in capital gains bonds. At Personalfn, we believe there is more than one way of doing this.

However, before discussing the various alternatives, let us understand what a capital gains liability is and how it arises.

If you sell any capital asset (like a house property), a capital gains tax liability can arise on the same. If the asset (property in this case) has been sold within 36 months from the date of purchase, it amounts to short-term capital gains. Conversely, if the asset is held for a period of more than 36 months, a long-term capital gain arises.

In case of assets like mutual funds, the holding criterion for determining long-term or short-term is reduced to 12 months. So if you hold the security for over 12 months, it qualifies for a long-term gain.

The following illustration explains how a capital gains are computed.

Table 1

Suppose you purchased a house property in March 1995 at a cost of Rs 1,500,000 and sold the same 10 years hence at Rs 3,000,000. Your profit on sale would be Rs 1,500,000. However for the purpose of computing capital gains, the purchase price has to be adjusted for inflation using the Cost Inflation Index (see Table 1).

The long-term capital gains will now amount to Rs 220,077. At a tax rate of 20% (for long-term capital gains), the tax liability amounts to Rs 44,015.

Now let us examine the various options available for managing the capital gains liability.

1. Invest in capital gains bonds

Assesses have the option of not paying any long-term capital gains tax by investing the profit (Rs 220,077) in capital gains bonds with a stipulated time period. Capital gains bonds are issued by specified institutions and tax benefits are available under Section 54EC of the Income Tax Act.

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For the purpose of claiming tax benefits, investments should be made within a period of 6 months from the date when the capital asset was sold. Similarly, investors are required to stay invested in the bonds for a period of 36 months from the date of investment. Redemption before completion of the 36-month period will negate the tax benefits.

Table 2 demonstrates the working on capital gains bonds. NABARD offers capital gains bonds with a coupon rate of 5.50% for a 5-year period. Investors have the option of liquidating their investments at the end of 3 years without affecting the tax benefits claimed.

Table 2

(*Returns adjusted for tax benefits)

Since investing in capital gains bonds entails not paying any long-term capital gains tax, the net amount (long-term capital gains less tax liability on the same) has been used for computing the returns. Similarly, interest earnings from the capital gains bonds are assumed to be taxed at the highest tax slab (30%, plus 2% for education cess).

In the above example, the investor would earn returns at 11.83% CAGR over the 3-year period. This option will appeal to investors with a low risk appetite and to those for whom not paying tax is a high priority.

2. Pay the tax and invest in other avenues

If you are not happy with the idea of locking away your gains in capital gains bonds for a 3-year period, you can explore the possibility of paying the capital gains tax liability and investing the balance in alternate avenues like mutual funds.

Table 3 lists returns clocked by some leading diversified equity funds and balanced funds.

Table 3

	3-year*
Diversified Equity Funds
HDFC [Get Quote] Top 200	66.33%
Franklin India Bluechip	59.91%
Sundaram Growth	55.55%
Balanced Funds
HDFC Prudence	53.89%
DSP ML Balanced	42.79%
FT India Balanced	37.64%

(Source: Credence Analytics; NAV data as on November 11, 2005. *Returns are Compounded, Annualised.)

Clearly the mutual fund schemes under consideration have clocked far superior returns vis-�-vis the capital gains bonds as seen in Table 3. However, equity-oriented schemes are high-risk investment avenues and expose investors to considerably higher levels of risk as compared capital gains bonds.

Secondly, unlike capital gains bonds, mutual funds don't offer assured returns. Finally the returns listed above are historical in nature.

While it would be difficult to predict how the equity markets will behave over the next 3 years, we believe a 15% CAGR return over this time frame seems like a reasonable one. Equity-oriented funds if held for a period of more than 12 months are exempt from any long-term capital gains tax liability; also dividends received from such funds are totally exempt from tax.

In such a scenario, investors will be better off paying tax and investing the balance in mutual funds rather than investing in capital gains bonds.

Table 4

(*Returns are Compounded, Annualised.)

3. Invest the gains in a residential house property

Section 54 and Section 54F of the Income Tax Act contains provisions whereby long-term capital gains can be utilised to acquire/construct a residential house property. If the necessary conditions (including the time frame within which the gains must be invested for buying/constructing a property) are fulfilled, the assessee is exempt from paying capital gains tax.

As in the case of capital gains bonds, the property acquired should not be transferred within a 3-year period from the date of transfer or construction; failure to adhere to the same will negate the tax benefits claimed.

As we had mentioned earlier, capital gains bonds are not the only means for managing your tax liability. Your decision to invest in capital gains bonds or otherwise should be determined by your risk appetite and investment objective among others.

For example, if you are content with the idea of a low-risk but assured-returns investment avenue, coupled with the prospect of not paying any tax, capital gains bonds are your calling. Alternately, you can consider paying up your tax liability and using the mutual fund route.

The key lies in being aware of the various options and making an informed choice.

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