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Sunday, February 18, 2018

LTCG Tax 2018 on Equities and Effective Strategies to Counter it.


Did you know that returns from equity are no more tax free? Long Term Capital Gains (LTCG) tax is here. Understand all about this new tax.
Did you know that there is a grandfathering clause within LTCG Tax, which allows you to realise your historical profits without paying LTCG Tax?
Did you know that you could still escape LTCG tax on new investments, if you are smart during the year?
Did you know that we are still under-estimating the massive impact LTCG Tax is likely to have on the long term prospects of the market?
Want to know all these and more....Read on... 

Background
Prior to 2018, LTCG Tax was already existing on every other profitable capital gains investment in India, including debt funds, real estate, gold etc. Equity was the only investment vehicle which was spared. Now, it is no more the case. Equity returns will now be lower than anticipated - without any doubt.

What is changing now, with LTCG tax?
1. Tax on Short term gains on equity (mutual funds or stocks held for less than 12 months) does not change. The tax stays at flat 15%, as was the case earlier.
2. Tax on Long Term Capital Gains on equity (mutual funds or stocks held for more than 12 months) has gone up from 0% to 10% flat.
3. Unlike the case of debt funds or real estate or gold, there are no indexation benefits attached to this 10% tax. It is flat 10% tax on the total gain. Actually, it comes out to be 10.04% if you include the cess.
4. Silver Lining in the dark cloud is that LTCG on equities is tax free up to Rs 1 lakh per financial year, which means that if your gain is up to INR 1 Lacs per year, you do not pay any LTCG still.
5. Some positive also is the Grandfathering clause. The acquisition cost of an asset for the purpose of computing capital gains will be the higher of the actual purchase price or the maximum traded price on Jan. 31. In other words, any gains accumulated before that date won't be taxed when the asset is sold.

What is the structural impact of this change?
The impact is not just the 10% tax. It is higher - much higher than what we can visualise right now. This taxation law change could change the way people prefer to invest their savings. Here are a few examples how.

1/ ELSS will lose some of its sheen to PPF/VPF for Sec 80C investing
Equity-linked savings schemes (ELSS) will now lose the tax-free status that made them among the favored options for investors looking to save tax. ELSS may not be the default option for tax saving. This will get the risk averse investors vying back to VPF and PPF or NPS to some extent. These will continue to be tax free while the gains from ELSS funds will be taxed at 10% flat. Well, ELSS can still yield high post tax returns compared to VPF or PPF but considering that there is more volatility and risk involved with equity, investors may not be as easily pulled towards taking that risk. If you want to save tax under Sec 80C, a combination of ELSS and PPF is now perhaps the best option. While ELSS generates higher returns, PPF provide a stable foundation with assured income.
Recommended blog : What is ELSS Scheme?


2/ ELSS will also lose some of its sheen over ULIPs
Low cost Ulips, sold online directly by insurance firms, can possibly provide returns comparable with ELSS over the long term. But unlike Ulips, ELSS offer greater flexibility to investors. They don’t have to make a multi-year commitment and can shift to another fund if a scheme is under performing. In case of under performance in a Ulip, the investor can only switch between funds offered by that Ulip. ELSS funds have lost some of their sheen but they still remain the best option in the 80C basket

3/ Equity Funds will become less preferred over Balanced/Debt Funds
Given the fact that equity funds are not allowed any indexation benefit, the tax disparity between equity and debt schemes has narrowed down, making debt funds and FMPs more attractive - considering the lower risk and stable income that flows from them. Gains from debt funds are eligible for indexation benefit which makes these schemes fairly tax-efficient. Indexation can significantly reduce the effective capital gains, reducing the tax liability for the investor. At times, the investor may not even incur any tax liability on the bond fund gains after indexation.

Recommended Post : Cost Indexation Base Year has shifted

4/ Short Term Market Volatility will increase
The stock market volatility may also go up now because the LTCG tax will result in a behavioral change among investors. Since the difference between the STCG and LTCG is only 5% now (15% vs 10%), few investors may wait for an entire year to sell. Investors who waited for an entire year just to avail of the tax benefits, even if they wanted to book profits earlier, won’t have to stay invested now. On several occasions, waiting for an entire year has proved to be costly for investors. Their decisions would be more based on market situations rather than tax implications now. Result : The stock market volatility will increase due to increased short term activity.

5/ Long Term will be less of an attraction
Over a long period like 10 or 15 years, an investor would lose a lot more money. The reason is that no equity investor is going to hold the exact same investments for such long periods. At some point, they would sell some of their holdings and buy something else. Given the structure of tax laws, capital gains would be taxed on each such switch, leading to less capital being available for compounding subsequently. The eventual impact would be quite large.

Recommended Post : How long in 'Long Term' in Equity?

6/ Mutual Funds finally has some edge over Stocks
Instead of buying and selling equity directly, a mutual fund investor can get the same returns but needs to buy and sell much less frequently. The trading is done inside the fund’s portfolio by the fund manager. However, as long as the investor holds on to the fund, there is no taxable event. This makes Mutual Funds a slight edge over stocks - as the movement from one set of stocks to other (within the fund) because of market driven decisions - will not attract any tax.

Recommended Post : Stocks Vs Mutual Funds


Strategies to reduce the impact of LTCG
LTCG is now a reality. There is no point cribbing and crying over it. We can only try and get smarter wrt the way we stay invested in equity. Here are a few strategies that might help you recover from this shock - to an extent..

1/ Make use of 1 Lac Tax Exemption every year
Make use of the tax exemption provision and book profits up to INR 1 Lac per financial year and reduce LTCG tax outgo. We must understand that we cannot carry forward the INR 1 Lac sum— i.e. we cannot claim INR 10 Lacs exemption over a 10 year period. So, given an opportunity, we should try and book profits each year. Instead of accumulating capital gains forever, investors now need to churn their portfolio (book profit and invest again in other assets) on a regular basis to lower their tax liability. Churning will work well for retail investors whose portfolio size is small. But it becomes less effective for high-net individuals and may not be worth the trouble. 

To illustrate, if an investor’s total equity corpus is INR 5 Lacs, his annual return at 12% will be just Rs 60,000. This entire capital gain can be made tax free by churning.  A word of caution here is that we must reinvest the proceeds and not divert them for consumption, or we will miss out on the power of compounding and put our goals at risk.
Recommended Post : How powerful can Compound Interest be?

2/ Low Cost ULIPs will be good
While the government has not tinkered with the tax structure of Ulips, investing in Ulips will work only for the informed investors, who understand their complex cost structures. Since the commission on low-cost Ulips is minimal, even zero, agents won’t push them. So, if you are not alert, you may be miss-sold high cost Ulips or other opaque insurance products such as traditional plans. High surrender charges is another issue with these products.



3/ Make use of Grandfathering Clause
While realising profits from your investments done anytime prior to 2018, make sure to use the grandfathering clause, which means that effectively, you pay tax only on the capital gains, if any, considering the cost of acquisition as Jan 31, 2018. 
Let us say, you purchased 3,000 Mutual Fund units in 2013 at an average cost of INR 100 per unit (Total investment of 3 Lacs). 
Today, you wish to sell them at the average cost of INR 200 (Selling price of 6 Lacs). 
This makes your capital gains to be INR 3 Lacs (6 Lacs - 3 Lacs). 
Without the grandfathering clause, you would have paid 10% flat tax on your gain of 3 Lacs i.e. INR 30,000. 
Now, assuming that the price of the units was Rs. 190 as on Jan 31, 2018. This makes your effective capital gains as 30,000 (3000 units * Rs 10 per unit profit) , and therefore zero tax liability (since the gain is less than 1 Lac) 
It is even possible that the unit price of the fund may be more than INR 200 as on Jan 31, 2018 - in which case you incur a fictional capital loss.

Why LTCG on Equity is highly opposed?
It is not that there were no new taxes introduced earlier. But this specific tax has come under a lot of opposition. And many of the reasons are justified, to a large extent. Here are the top reasons, why we feel that this taxation is unjustified.

1/ Charging both STT and LTCG are unfair
The securities transaction tax (STT) was introduced a decade back as an alternative to LTCG tax on equities. The reason for introducing STT was ease of implementation and non dependence on the investor to disclose his or her capital gains. Thus, retaining STT, along with LTCG tax introduction was a bigger shock for investors. Logically, there should be just one tax.

2/ No indexation benefit 
There is no indexation benefit - which makes it that much unfair. LTCG tax is 10% without indexation for equities, it is 20% for debt funds with indexation benefit. No indexation means that we pay tax even if the gain is only an inflation adjusted return. Unfair, isn't it? Inflation indexation is allowed for every other form of long-term capital gains in India—bonds, real estate, unlisted equity to name just a few. It is a cornerstone of fair taxation that the government cannot ask you to pay a tax on values that increase because of inflation. There is no justifiable reason to ignore this basic taxation principle.

Be Careful
After the Budget announced the tax on LTCG, insurance companies have started giving ads highlighting the tax-free returns from insurance policies and Ulips. Do not get lured with the tax free status of insurance policies. Being tax free is good but the there are more important criteria to check e.g. the post tax returns, liquidity, flexibility, safety, need etc. before you decide on any investment vehicle.

Summary
Grandfathering of acquisition cost and 1 Lac exemption every year does provide some relief to the retail investor. But overall, the move to tax long term capital gains without any indexation benefit seems unfair and unrealistic to be sustained in the long run. Till that time, the retail investor must implement whatever strategies possible to maximize post tax returns.

Recommended Book : From the Rat Race to Financial Freedom

Cheers

Manoj Arora
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