Selling shares? Remember to apply FIFO
We receive a number of queries on the subject of computation of capital gains with respect to shares/mutual fund units. And as per our archives, the last time we had written on this topic was well over two years ago. Hence a reiteration or revisitation of the basic principles involved is quite due.
Earlier, investors could pick and choose the shares to sell, depending upon whether such shares were long-term or short-term assets. The price paid for each purchase also played a part in the tax planning exercise. For example, bonus shares, where the cost is nil (resulting in a higher profit) could be chosen to sell along with those which would result in a substantial loss. This exercise essentially minimized the tax outgo.
However, in the current dematerialised environment, such a tax planning exercise isn’t as easy as it was earlier. This is on account of Sec. 45 (2A) of the Income Tax Act that specifies that for shares that are sold in the demat form, the First in first out (FIFO) system had to be applied.
So basically, for computing capital gain chargeable to tax, the cost of acquisition and period of holding of any security shall be determined on the basis of the FIFO method. This means that the investor no longer has the discretion to select the specific lot of the scrip to be sold — the one that is dematerialised first would be deemed to have been sold first.
Also, it may so happen that you may have bought shares in the demat form first and then submitted your old physical shares for dematerialisation. For example, let’s take the case of Ravi. He had purchased some HDFC shares way back in 2001 that he had forgotten to get dematerialised. He submitted the same for dematerialisation only in 2011 by which time he had already purchased shares in the company in the electronic form. How will the FIFO method work in this case? Consider the following table (Ravi’s purchase of HDFC shares). Let’s say, Ravi sells 175 shares. Under the FIFO system, the first entry i.e. shares purchased on May 2, 2011 would be deemed to have been sold first. The next 75 shares would come out of the lot that had been dematerialised next i.e. shares purchased in 2001.
Points to note
The date of dematerialisation has nothing to do with the tax treatment thereof. In the first lot, though the shares have been dematerialised on May 2, the date of acquisition still remains April 30, 2011. This concept becomes significant with the next entry. Note that for the next entry in the demat
statement, the shares have been dematerialised only on October 5, 2017. Does this make it a short-term asset? The plain and simple answer is No. The date of acquisition of the shares is and still remains March 2001, no matter when you submit the shares for dematerialisation.
The second important thing to note is that the first two entries represent shares purchased in 2011 and 2001 respectively, thereby making the same long-term assets. Remember, that long-term capital gains are now taxable. If the sale of shares purchased on November 25, 2017 (the third entry
in his demat statement) results in a short term loss, it can be used to set-off other short-term or long-term gains. However, such a tax planning exercise isn’t possible due to the FIFO rule.
However, there could be a way out. Note that the FIFO system is to be applied account wise. In the depository system, the investor can have multiple accounts. He may have shares of the same scrip credited in more than one account. For example, had Ravi owned HDFC shares purchased less than one year ago in some other depository account, he could have chosen those to sell even though they had been bought after 2001 and 2011 respectively. In other words, FIFO is applied per account individually and not collectively to all demat accounts of the investor.
Last but not the least, FIFO is applicable only to shares and securities that are dematerialised. Which means, this system is not applicable to mutual fund units. In the case of mutual fund units, the investor can definitely pick and choose the particular lot to sell. However, the tax treatment remains the same. In other words, in the absence of HDFC shares, Ravi could very well have sold units of an equity oriented fund to get the same tax benefit!