The Core Rule: Section 87A Does Not Apply to Special-Rate Capital Gains
This is one of the most common points of confusion in equity taxation — and one of the most consequential. Many taxpayers (and some tax software tools) incorrectly apply the Section 87A rebate against STCG under Section 111A and LTCG under Section 112A. The Income Tax Department has explicitly clarified this is not permitted.
The rule: Section 87A rebate is available only against tax computed on income taxed at slab rates. Capital gains taxed at special flat rates (20% for STCG under Section 111A, 12.5% for LTCG under Section 112A) are excluded from the rebate calculation.
For FY 2025-26 (AY 2026-27), this matters more than ever given the significant changes made in Budget 2025.
What Changed in Budget 2025
The Finance Act 2025 made a major change to Section 87A under the new tax regime:
- New regime rebate limit raised: Individuals with total income up to ₹12 lakh (up from ₹7 lakh) pay zero tax under the new regime after applying the Section 87A rebate of up to ₹60,000.
- Old regime rebate unchanged: Individuals with total income up to ₹5 lakh get a rebate of up to ₹12,500 under the old regime.
Despite these higher limits, the restriction on special-rate income remains unchanged. Capital gains taxed at 20% (STCG) or 12.5% (LTCG) are not eligible for the 87A rebate — even if the taxpayer's total income (including those gains) falls below ₹12 lakh.
How the Restriction Works in Practice
The computation of tax and rebate works in two separate steps:
- Step 1 — Compute tax on slab-rate income: All income other than special-rate capital gains (salary, IFOS, business income, etc.) is taxed at normal slab rates. The Section 87A rebate is applied against this tax if total income ≤ ₹12 lakh (new regime) or ≤ ₹5 lakh (old regime).
- Step 2 — Compute tax on special-rate income separately: STCG under Section 111A is taxed at 20%. LTCG under Section 112A on gains above ₹1.25 lakh is taxed at 12.5%. This tax is added on top — the rebate does not reduce it.
Worked Example
Suppose a client (new tax regime, FY 2025-26) has:
- Salary income: ₹9 lakh
- STCG from equity (Section 111A): ₹2 lakh
- Total income: ₹11 lakh
Many people assume: total income < ₹12 lakh → full rebate → zero tax. This is wrong.
| Component | Amount | Tax |
|---|---|---|
| Tax on ₹9 lakh salary (new regime slabs) | ₹9,00,000 | ₹40,000 |
| Section 87A rebate (salary income ≤ ₹12L) | — | −₹40,000 |
| Tax on ₹2 lakh STCG at 20% | ₹2,00,000 | ₹40,000 |
| Net tax before cess | ₹40,000 | |
| Health & Education Cess at 4% | — | ₹1,600 |
| Total tax liability | ₹41,600 |
The 87A rebate eliminated the slab-rate tax on salary, but the STCG tax of ₹40,000 is fully payable. The client's total income is below ₹12 lakh, yet they owe tax — a surprise to many taxpayers.
The FY 2024-25 Controversy: What Happened
In the AY 2025-26 ITR filing season (FY 2024-25 returns), there was significant controversy. Some taxpayers — relying on earlier ITAT rulings and tax software that computed 87A rebate against STCG — filed returns claiming the full rebate. The Income Tax Department's portal subsequently issued deficiency notices disallowing the rebate on Section 111A/112A gains.
Several ITAT rulings had earlier held that the rebate should be allowed as long as total income fell within the threshold. However, the IT Department's position — and the correct legal interpretation for FY 2025-26 — is that the word "income-tax" in Section 87A refers only to tax on income taxable at normal rates, not special flat-rate tax on capital gains.
For FY 2025-26 returns, CAs should follow the IT Department's position and not claim 87A rebate against STCG or LTCG from equity.
How the Rule Interacts with the ₹1.25 Lakh LTCG Exemption
Section 112A already provides a ₹1.25 lakh annual exemption on LTCG (Finance Act 2024). The rebate question only arises when LTCG exceeds ₹1.25 lakh — the excess is taxed at 12.5%.
The two provisions are independent:
- The ₹1.25 lakh exemption reduces the taxable LTCG amount before computing the 12.5% tax.
- The Section 87A rebate question arises only after computing the 12.5% tax on the balance — and the answer is: the rebate does not apply.
Which Tax Regime Is Better for Equity Investors?
The regime comparison for equity-heavy clients (FY 2025-26):
| Scenario | Old Regime | New Regime |
|---|---|---|
| Total income ≤ ₹5 lakh (including cap gains at slab) | Zero tax (87A rebate) | Usually better due to higher ₹12L limit |
| Salary ₹8–12 lakh + significant STCG | Higher slab rates but deductions (80C etc.) | Lower slab rates, no deductions, but STCG tax unchanged |
| Salary > ₹15 lakh + large LTCG | Deductions can reduce salary tax significantly | Lower slabs but fewer deductions |
| Mainly capital gains, minimal salary | Likely better if deductions are claimed | Better if no major deductions, income ≤ ₹12L ex-gains |
The key insight: since capital gains are taxed at flat rates (20%/12.5%) regardless of regime, the regime choice only affects the slab-rate portion of income. For clients whose primary income is from equity trading, the regime with lower effective slab rates on other income wins — which is typically the new regime for most income levels in FY 2025-26.
Practical Impact on ITR Filing: Schedule OS and Schedule SI
In ITR-2 and ITR-3, special-rate income (STCG and LTCG) is reported in Schedule SI (Special Income), which is taxed separately from slab-rate income. When computing the rebate in Schedule AMT or the main tax calculation, only the slab-rate tax base is eligible for 87A rebate.
Common error in ITR filing software: some tools compute 87A rebate on total tax (including SI tax) when the option for "new regime" is selected. Always verify the tax computation sheet before filing — check that Schedule SI shows STCG/LTCG tax computed at the flat rate without rebate offset.
Common Mistakes CAs Should Avoid
- Claiming 87A rebate on STCG: Even if total income is ₹11 lakh (below the ₹12L limit), the STCG tax at 20% is fully payable.
- Trusting software output without verification: Some legacy ITR preparation software still computes 87A against total tax. Always review the final tax computation.
- Confusing the ₹1.25 lakh LTCG exemption with 87A: These are different. The exemption reduces the taxable amount; the rebate question arises after the tax is computed.
- Applying old regime 87A limits (₹5 lakh) to new regime clients: New regime clients (FY 2025-26) get the ₹12 lakh limit and ₹60,000 rebate — but only on slab-rate income.
- Missing the cess: After applying 87A, 4% health and education cess applies to the remaining tax. Rebate reduces tax before cess is computed, not after.
How FirstReports Helps
When consolidating a client's capital gains across multiple brokers, FirstReports clearly separates STCG (Section 111A), LTCG (Section 112A), and slab-rate income — making the tax computation transparent. The output shows exactly how much STCG and LTCG tax is due at flat rates, distinct from the slab-rate tax base, so CAs can correctly apply (or not apply) the Section 87A rebate without errors.