The ₹12 lakh "tax-free" rule has a gap in it this year — and it's shaped like your capital gains

Every July brings the same conversation. A salaried client, or a small trader who bought some mutual funds during the year, sits down and says: "My income is under 12 lakh, so there's no tax this year — right?" For the last two assessment years, thanks to a fight fought and won in the Bombay High Court, that was often true even when the client had sold some shares along the way. This year, that answer has quietly become wrong for a large number of them, and the reason is not a portal glitch this time — it is the law itself.

The section 87A rebate is what makes income up to ₹12,00,000 effectively tax-free under the new regime: the tax computed on that income is wiped out, up to a ceiling of ₹60,000. What has changed is what counts as "that income" when capital gains are in the mix.

What taxpayers won last year

For AY 2024-25, the income-tax e-filing utility was quietly modified after 5 July 2024 to stop taxpayers from claiming the section 87A rebate against short-term capital gains taxed under section 111A — even though nothing in the statute at that time said the rebate could not apply to such gains. The Chamber of Tax Consultants challenged this in the Bombay High Court, arguing the tax department had changed its own software mid-year without any change in the underlying law. The Court agreed: its December 2024 interim order and the final ruling that followed held that the rebate applies to a taxpayer's total tax liability, including tax charged at special rates, unless the law explicitly says otherwise — and at that time, it did not. The Court directed CBDT to fix the utility and extended the window for revised and belated returns so affected taxpayers could actually claim it.

An Ahmedabad bench of the Income Tax Appellate Tribunal reached the same conclusion soon after, in a case involving a taxpayer's short-term capital gains for an earlier year: for the years then in question, the tribunal found no express bar in sections 87A or 111A preventing the rebate from being set against tax on such gains. Both rulings were correct readings of the law as it stood — and both were about years before the one now being filed.

The Bombay High Court read the law as it stood. Parliament has since rewritten the text those judges were reading — and this year's return is filed under the new version, not the old one.

What Parliament changed for this year

The Finance Act, 2025 inserted an explicit proviso to section 87A: for computing the rebate, tax on income chargeable at special rates — short-term capital gains under section 111A, long-term capital gains under sections 112 and 112A, and certain other special-rate items such as lottery or game-show winnings under section 115BB — is simply left out of the calculation. This applies from AY 2026-27, which is the return due on 31 July or 31 August this year for most individuals. The ground the Bombay High Court and the Ahmedabad tribunal stood on — an absence of any explicit statutory bar — has been removed for this year onward. A client who read last year's news coverage of "taxpayers win Section 87A fight" and assumes it still applies is relying on a ruling about a law that no longer exists in that form.

How the rebate actually works now

Two mechanics are worth separating, because conflating them is where the confusion starts. First, eligibility: whether you qualify for the rebate at all is tested against your total income excluding special-rate income — so a taxpayer with ₹9,00,000 in salary and ₹2,50,000 in short-term capital gains is tested against the ₹9,00,000 figure, not the combined ₹11,50,000, and comfortably qualifies. Second, quantum: once you qualify, the rebate — capped at ₹60,000 — can only cancel the tax computed on your normal, slab-rate income. It cannot touch a single rupee of tax computed at a special rate. In the illustration above, the salary tax of roughly ₹30,000 is wiped out entirely; the ₹52,000 of tax on the short-term capital gains is payable regardless of how comfortably the taxpayer's total income sits under ₹12 lakh.

What to check before filing

This affects far more returns than it sounds like it should, because equity mutual funds and direct shares are now common even for taxpayers who think of themselves as simple salary-and-savings filers. Before filing this year's return — ITR-2 is the common form for salary plus capital gains, with no business income — separate every rupee of income into its two tracks. List out short-term equity gains, long-term equity gains beyond the ₹1,25,000 annual exemption, gains on debt funds or unlisted shares, and any lottery, game-show or virtual digital asset income, and compute tax on each at its own rate before assuming the ₹60,000 rebate absorbs it. Check whether any of the ₹4,00,000 basic exemption is still unused after your normal income — if it is, it can be applied against the special-rate income first, which genuinely does reduce the bill, unlike the rebate. Do not extrapolate from a prior year's return, a friend's experience from AY 2024-25, or a generic tax calculator that has not been updated for this specific carve-out; and do not expect the e-filing utility to make a mistake in your favour this year — it has been built to reflect the amended law, not the litigation that preceded it.

Sources

This article is general information, not professional advice. Rules change; verify current provisions or contact the office for advice on your situation.