Beauty lies in the eye of the beholder. But lately, 'Art' has emerged as an alternative investment instrument, even as the status tag continues to be attached to art and artifacts. Perhaps one of the main causes for this increasing shift towards investments in art, are the volatile stock markets and the low rates of returns on the traditional means of investments.

However, as is always the case, can taxes be far behind? The booming art market caught the Finance Minister's eye a few years ago and loopholes were duly plugged, as Rahul Kapoor finds out.

Rahul Kapoor an avid collector based in India, invested in a painting of the famous painter M.F. Hussain. He intends to hold the said investment for a period of five to ten years. However, as the Government vide its Union Budget 2007, amended the Income Tax Act, 1961 (Act) to impose capital gains tax on sale of art work by a collector in works of art. Now Rahul Kapoor is concerned regarding the tax implications arising on sale of his art investment. Let us examine these implications..

Rahul Kapoor, could before this amendment contend that art work he owned constitutes personal effects like wearing apparel (clothes) or furniture. On an occasional sale of an art work he could argue that it was a capital receipt (and not income) and therefore not subject to tax under the Act. However, as mentioned above, now the sale of art works falls under the purview of Act as 'Income from capital gains'. The definition of capital assets inter alia now includes personal effects such as drawings, paintings, sculptures and any work of art.

Profit on sale of capital asset is treated as capital gains. The capital gains could be segregated into 'short term capital gains' or 'long term capital gains' based upon the period of holding of the capital asset. A capital asset shall be treated as a 'short term capital asset' if it is held for a period of not more than three years immediately preceding the date of its transfer.

The gains arising on sale of such an asset will be treated as 'short term capital gains'. However, if the capital asset is held for more than three years, the same shall be treated as a 'long term capital asset' and the gains arising on such a sale will be classified as 'long term capital gains'.

For the purposes of computing the gains arising on the sale of capital assets, the cost of acquisition / improvement of the asset and any expenses incurred on transfer of the capital asset are reduced from the full value of the sale consideration received. However, if Rahul Kapoor acquires the art work as a gift or through inheritance, the cost of acquisition of the art work for him would be deemed to be the cost for which the previous owner of the art work acquired it, as increased by the cost of any improvement incurred or borne by the previous owner or by Rahul Kapoor himself, as the case may be.

Now, if the painting sold by Rahul Kapoor qualifies as a long term capital asset, he would be entitled to claim a higher cost of purchasing / improving the capital asset by indexing the original cost of acquisition / improvement. In such a situation, the gains arising therefrom would be chargeable to tax at the rate of twenty percent.

Where Rahul Kapoor earns gains from transfer of the painting which qualifies to be a long term capital asset, he would be exempt from payment of whole / part of taxes thereon if the long term capital gains / net sale consideration is reinvested by him in certain specified securities. If the painting sold by Rahul Kapoor is a short term capital asset, the gains arising to him would be chargeable to tax at the rate of thirty percent, assuming that Rahul falls in the highest tax bracket.

Where the sale of painting is made by Rahul Kapoor to the Government or a University or the National Museum, National Art Gallery, National Archives or any such other public museum or institution as may be notified by the Central Government, the same shall not be regarded as a transfer of capital asset and accordingly not be chargeable to capital gains tax.

Further, if the gains arising to Rahul Kapoor are chargeable to tax in another country, Rahul Kapoor shall also be entitled to claim a benefit of taxes, if any paid in the other country in accordance with the Double Taxation Avoidance Agreement between India and the other country.

What about losses? True, a M.F. Hussain painting is unlikely to depreciate in value. But assuming that a loss has been incurred on sale of such painting, what then? In case of a long term loss on sale of the painting, Rahul Kapoor shall be entitled to set off the same only against long term capital gains earned by him on sale of other assets during the same year.

However, if Mr Kapoor sells off the painting before a period of three years and incurs any short term capital losses, the same shall be entitled to be set off against any capital gains (ie long term or short term) earned by him. If Mr Kapoor does not earn any gains during the same year in which losses have been incurred by him, he shall be entitled to carry forward the said losses for a period of eight years and set- off the same against future gains to be earned by him. In such a situation, long term capital losses would be eligible to be set off only against long term capital gains and short term capital losses would be eligible to be set off against any capital gains.

Given that Rahul Kapoor is investing in a painting of M.F. Hussain as a means of alternative investment, he could also consider investing into units of unlisted art funds / schemes launched by various financial institutions. Art funds typically operate by pooling in money from select investors and use it to buy art objects that have huge appreciation potential. Such an investment will enable Rahul Kapoor to take advantage of the expertise of the fund manager as well as assist him in minimizing his risk of directly investing in art. The tax implications on Rahul Kapoor with regard to sale of units of an unlisted art fund would be similar as indicated aforesaid for sale of art.

(The authors are senior tax professionals, Ernst & Young)