Whether replacing the phrase 'long-term capital asset' with 'long-term capital gain' affects a taxpayer from taking the benefit of section 54EC

Introduction

Section 54EC of the Income Tax Act, 1961 intends to incentivise, wherein the assessee can save tax on capital gain in case the assessee invests in certain bonds as specified by the government. This section is now replaced with section 85 of the Income Tax Act, 2025, which shall be effective from 1st April 2026. This section now replaces the phrase of section 54EC of the old act 'capital gain arises from the transfer of a long-term capital asset' with 'long-term capital gains', i.e., long-term capital asset has now been changed to long-term capital gain. Now the question arises whether this change has in any way affected the exemption available to the assessee. In this regard, two divergent views exist

1st Opinion - Section 85 intends to take away the benefit from assessee holding a depreciable long-term capital asset

Section 50 states that in the case of a depreciable asset held for long-term, the gain for the purpose of section 50 shall be treated as capital gain arising out of a short-term capital asset. This provision was considered by the Hon'ble High Courts and the Supreme Court, wherein, in common parlance, it was held that this deeming fiction created under section 50 is limited to computation of capital gain and it does not affect any other section which includes sections where capital gain tax exemptions are provided based on certain investments made which includes section 54EC or provisions that deals with taxation of capital gains. This essentially means that if a person held any asset for the long term and claims depreciation on it, then computation shall be made as per section 50; however, he can still save taxes by making investments in specified bonds under section 54EC.

In CIT v V.S. Dembo [1] The court came across a similar situation where assessee sold a loading platform and earned capital gain over it, and he claimed capital gain exemption under section 54E; however, the department denied the exemption, believing that the deeming fiction created in section 50 extends to section 54E as well and therefore, as the asset is a short-term capital asset, no exemption can be claimed. However, contrary findings were given by the Hon'ble High Court, which was later upheld by the Hon'ble Supreme Court, and the reasoning for the same was borrowed from the Hon'ble Bombay High Court judgement in the matter CIT v. ACE Builders (P.) Ltd.[2], where three reasons were furnished

'Firstly, there is nothing in Section 50 to suggest that the fiction created in Section 50 is not only restricted to Sections 48 and 49 but also applies to other provisions. On the contrary, Section 50 makes it explicitly clear that the deemed fiction created in sub-sections (1) & (2) of Section 50 is restricted only to the mode of computation of capital gains contained in Sections 48 and 49. Secondly, it is well established in law that a fiction created by the legislature has to be confined to the purpose for which it is created. ......... Thirdly, Section 54E does not make any distinction between depreciable assets and non-depreciable assets, and, therefore, the exemption available to the depreciable assets under Section 54E cannot be denied by referring to the fiction created under Section 50.'

It is believed that, as section 54EC has now changed the wording from 'capital gain arises from the transfer of a long-term capital asset' to 'long-term capital gains'. Moreover, deeming fiction created by section 50 was not applicable to section 54EC because section 54EC doesn't talk about the nature of capital gain; it talks about the nature of the asset transferred, and therefore, the asset shall be a long-term capital asset because of its holding period. Now, as per the new section i.e. section 85, it is 'long -term capital gain', so now as it talks about the capital gain, therefore deeming fiction under section 78, which replaced section 50 in the new act, can travel to section 85 which means a depreciable asset held for long term, gains arising out of which are deemed to be capital gains arising out of a short term capital asset for the purpose of section 85 shall be interpreted as short term capital gain only, however the asset is a long term capital asset.

Therefore, before the implementation of the Income Tax Act, 2025, we had a long-term capital asset, so the deeming fiction of section 50, which treated it as a short-term capital gain, did not travel to section 54EC. However, the amendment now includes 'short-term capital gain,' as both sections are talking about capital gains only, as section 85 only gives benefit in case of investment made from long-term capital gains; therefore, this benefit shall not be available for the assessee having short-term capital gain which is earned through transfer of long-term capital asset which is depreciable in nature. Therefore, this legislative amendment has now, in a way, overruled the judgment of the Hon'ble Supreme Court.

2nd Opinion - Benefit underSection 85 is available with assessee transferring a depreciable long-term capital asset

The view expressed above seems erroneous because the intend which is apparent through the wordings of the court clearly states that the reason why court didn't allow the deeming fiction created under section 50 to travel into section 54EC or section 54E is because of the workings (wordings?) of section 50 which states that section 48 and 49 shall be subject to section 50 and it shall be limited to the computation only i.e. deeming fiction is only limited to the purpose of computation and not anyway beyond that. The same can be understood through the judgement of the Hon'ble Bombay High Court in the matter of CIT v Manali Investment [3], wherein the respondent-assessee had, during the subject assessment year, sold its meters and transformers on which it had claimed depreciation. On sale, the assessee claimed long-term capital gains and sought to set off the same against its carried forward long-term capital loss in terms of Section 74 of the Income Tax Act, 1961 ('Act' for short). The assessing officer disallowed the claim and held that, in view of section 50 of the Act, the gain is in the nature of short-term capital gain. The CIT (A) upheld the order of the AO, while ITAT held in favour of assessee, which was later upheld by the Hon'ble High Court. Relevant extract is as follows:

'3. On further appeal, the Tribunal by the impugned order has allowed the claim of the respondent - assessee to set-off its long term losses in terms of Section 74 of the Act against the long term capital gains on sale of transformers and meters. This was by following the decision of this Court in the matter of CIT v. Ace Builders (P.) Ltd . In the case of Ace Builders (P) Ltd (supra), this Court held that by virtue of Section 50 of the Act only the capital gains is to be computed in terms thereof and be deemed to be short-term capital gains. However, this deeming fiction is restricted only for the purposes of Section 50 of the Act and the benefit under Section 54E of the Act which is available only to long term capital gains was extended. In this case, the Tribunal held that the position is similar and the benefit of set-off against long term capital loss under Section 74 of the Act is to be allowed. Further, an identical issue with regard to set off against long term capital loss arose in an appeal filed by the Revenue in the matter of CIT v. Hathway Investments (P.) Ltd, being Income Tax Appeal (L) No.405 of 2012.

This Court by its order dated 31 st January 2013 refused to entertain the appeal filed by the Revenue. The Revenue has not been able to point out any distinguishing features in the present case warranting a departure from the principles laid down by this Court in the matter of Ace Builders (P.) Ltd. (supra) and in our order dated 31 st January, 2013 in Income Tax Appeal (L) No.405 of 2012.

4. In view of the above, we see no reason to entertain the proposed re-framed question of law. Accordingly, the appeal is dismissed with no order as to costs.'

This shows that the view expressed by the courts is to read section 50 in isolation from any other section and deeming fiction is restricted to the computation itself and not for any other purpose it may relate to, such as set off, carry forward or claiming exemption. Moreover, the interpretation that says deeming fiction created by section 50 is not applicable to section 54EC because section 54EC doesn't talk about the nature of capital gain, rather it talks about the nature of the asset transferred, cannot be inferred from the judgement itself and therefore the conclusion leading to this interpretation is itself flawed.

Therefore, as the courts are consistent with a view that section 50 needs to be read in isolation from any other section, there is a legislative intent to travel this presumption to go beyond section 50. This means the amended section 85 should be read separately from section 78, which essentially means that while reading section 85, we will have to assume as if no deeming fiction has been created. Section 85 states 'long-term capital gain,' which, as per section 2 (68) of the new act, is a capital gain arising from the transfer of a long-term capital asset. Therefore, making such changes cannot dilute the effect of the judgement of the Hon'ble Supreme Court in V.S. Dembo.

Conclusion

The change in the statutory language to a 'long-term capital gains' instead of the 'transfer of a long-term capital asset' under Section 85 of the Income Tax Act, 2025, is certainly an interpretational challenge, especially where the depreciable assets are subject to the deeming fiction. Nevertheless, a close examination of judicial precedents and the scheme of legislation, under which this change was introduced, implies that this change alone might not be enough to deprive the benefit of exemption.

The deeming fiction in section 50 has always been strictly limited by the courts, most famously CIT v. ACE Builders (P.) Ltd. and V.S. Dempo, that it extends only to the mechanism of computation, and not to exemption clauses. This doctrine has been restated in later cases and strengthens the notion that legal fictions are to be used at all only to the extent that they are established. By the settled position, although Section 85 now refers to the term long-term capital gains, the gains must nonetheless be interpreted in the substantive sense, i.e. as a result of the disposition of a long-term capital asset.

The new Section 78 (which is similar to Section 50) deeming provision must, therefore, be limited to calculation and not affect eligibility to exemption. To that end, it is more convincing that the amendment does not implicitly have an overriding effect on judicial interpretations. Depreciable long-term capital assets should be transferred by taxpayers who still should be able to be exempted under Section 85, although other requirements should be fulfilled. Any other interpretation would have to be a clear and explicit legislative directive, which currently does not seem to exist.

[1]  Commissioner of Income Tax, Panji Versus V.S. Dempo Company Ltd. - 2016 (10) TMI 62 - Supreme Court

[2]Commissioner of Income-Tax Versus Ace Builders (P.) Ltd. - 2005 (3) TMI 36 - BOMBAY HIGH COURT

[3]The Commissioner of Income Tax – 19, Mumbai Versus M/s. Manali Investment - 2023 (3) TMI 1627 - BOMBAY HIGH COURT