As we enter the last quarter of the current fiscal year, we reiterate our annual article on the optimal tax treatment of losses. Adjustment of losses (whether on house property, capital gains or business income) is an important yet often overlooked aspect of the tax return filing process.
By way of a background, the Income Tax Act allows the taxpayer under certain conditions to set off loss against income thereby reducing the net tax liability. If such loss cannot be fully set off, the balance remaining can even be carried forward for set off in the future years. It is necessary for every taxpayer to properly understand and take advantage of the facilities in this regard as this will enable the tax return to be optimized for minimum tax payment.
Inter Source Adjustment
There are five heads of income under which any taxpayer can earn income. These are Salary, House Property, Income from Business or Profession, Capital Gains and the residuary Income from Other Sources. Now, by definition, there cannot be a loss from Salary and Income from Other Sources. However, a person could suffer losses from other heads of income. Now the first and foremost rule is that loss under one head of income has to be first adjusted against any income from the same head. This is known as Inter-Source adjustment. For example, say someone who has two different businesses, one that is loss making and the other one profit making, then the loss from the first one can be set off against the profit from the second one. Or say if you have two properties, one for self occupation and the other one given out on rent, then the loss from the first property (on account of the mortgage interest) can be set off against the rental income from the second property. The only exception in this regard is to do with long-term capital gains which we shall examine later on in the article.
Inter Head Adjustment
Now say after setting off the loss as above, there still remains some balance. This balance loss can then be set off against income from other heads. This is known as Inter-Head adjustment. For example, a taxpayer who has a single self occupied house property bought on mortgage will necessarily show a loss. This is because the Annual Value of a single self occupied property is taken to be nil and the adjustment of any interest will result in a negative value. Now, such a loss may be adjusted against salary income or say income from business, if any. There are two exceptions to the rule of Inter Head Adjustment —
l Losses under Capital Gains cannot be set off against income from any other head.
l Loss from business or profession cannot be setoff against salary income.
Carry Forward of Losses
And last but not the least, any loss that cannot be setoff either against the same head or under other heads because of inadequacy of income, may be carried forward to be set off against income of the subsequent year. Such a carry forward exercise may be done for 8 years. After 8 years, if the loss hasn’t yet been fully set off, it has to be written off and cannot be used for tax saving. The important point to note is that for carry forward losses, only Inter Source adjustment is available in the subsequent years and not the Inter Head one. The following table encapsulates the above discussion.
Adjustment of Loss under Capital Gains
The first and foremost point to note about losses under the head Capital Gains is that they have a boundary i.e. they have to be adjusted against other capital gain income only and other incomes are not available for the setting off. In other words, the Inter Head adjustment referred to earlier is not available in the case of capital losses.
The second condition in this regard is that long-term capital loss can only be adjusted against long-term capital gain. Or putting it differently, short-term capital gain may not be used to set off any long-term capital loss. However, short-term capital loss can be set off against any taxable long-term capital gain or short-term capital gain.
In a nutshell, long-term capital loss adjustment can be only done against long-term capital gains whereas short-term capital loss adjustment can be against any capital gains, long-term or short-term.
Lastly, if the income from a particular source is exempted from tax, loss from such a source cannot be set off. Which means, any long-term loss on sale of shares or equity oriented mutual funds cannot be set off at all as the long-term gain from the sale of these instruments is exempted. In other words, loss of profits must be a loss of taxable profits.
The following example explains the above provisions.
Now, LTCL from shares cannot be set off since the LTCG from this source (in this case Rs. 60,000) is exempted. The LTCL from non-equity MFs of Rs. 25,000 can only be adjusted against the LTCG from sale of gold. Therefore, only Rs. 15,000 can be adjusted and the balance Rs. 10,000 will be non-adjustable. Lastly, the Rs. 40,000 STCL from sale of shares can be adjusted against the Rs. 50,000 STCG and only the balance Rs. 10,000 STCG would be taxable.
Lastly, note that for being eligible to carry forward and set-off any loss, it is important to file the tax return by the specified due date. If the loss return is submitted after the due date, the Board may condone the delay only if it is satisfied that it was due to genuine hardship on the part of the taxpayer (Circular No.8/2001 dtd. 16/5/2001).
(The authors may be contacted at wonderlandconsultants@yahoo.com)
