Dhaval Kapadia, Director, Portfolio Strategist, Morningstar Investment Adviser (I) Pvt. Ltd., wrote this post for StocksMarket.in where it initially appeared.
In the Union Budget 2018, the government introduced Long Term Capital Gains, or LTCG, tax on listed equities and equity-oriented mutual funds, starting April 1, 2018.
LTCG made on stocks or equity mutual fund units, in excess of Rs 1 lakh, will be taxed at 10% (plus cess) without indexation benefit, if sold after March 31, 2018.
The holding period of more than 1 year is considered as long-term. On the other hand, holding period of one or less than one year is considered as a short- term and it continues to attract a tax of 15% (plus cess).
Dividends received from equity-oriented mutual funds will also attract a tax of 10 percent (plus cess). However, long-term capital gains up to 31st January 2018 has been grandfathered i.e. any mark-to-market gains made till 31st January 2018 will not be taxed.
It effectively means that, from taxation point-of-view, the cost of acquisition to be considered will be the stock’s price/ unit’s net asset value, or NAV, as on January 31, 2018; not the actual cost of acquisition.
For e.g. an equity mutual fund unit was purchased on January 1, 2017 for Rs 30, as on January 31, 2018 its NAV rose to Rs 40. While selling this unit on June 30, 2018 the NAV reaches, say Rs 42, then the capital gains that can be taxed is Rs 2 (42-40).
Up till now, one could rebalance their equity portfolio, or trim exposure to an underperforming fund in favour of a fund that was expected to do well, after completion of one year, without attracting any tax or without any consideration about the amount sold.
In the short term, the entire amount received from selling of units could be reinvested in an efficient manner. However, now, every time one sells units, capital gains made in excess of Rs 1 lakh will attract 10 percent tax, thereby reducing the amount of capital available for compounding going ahead.
Thus, every time one sells and reinvests, not only would they attract tax, they would also be compromising on the wealth creation potential of their corpus.
Hence, one would need to re-evaluate their existing financial plan, to factor in the impact of this tax on the forecasted value of the corpus. For e.g. frequency of rebalancing, amount to be invested, an amount that can be withdrawn etc. would probably change.
India used to tax LTCG on equity till 2003-04, with indexation benefit. A year later, Securities Transaction Tax, or STT, was introduced in its place, for transactions done on recognized stock exchanges.
However, now LTCG tax has been re-introduced without indexation benefit and STT continues to be levied. Indexation helps one to inflate the cost of acquisition using the cost inflation index, thereby reducing the amount that is to be considered as capital gains. The benefit of indexation on long-term gains is available on bonds, gold, unlisted equities etc.
However, it must be noted that the holding period for the capital gains to be considered as long-term is 3 years. Capital gains for holding period less than 3 years will be considered as short term.
The short-term capital gains for these instruments will be taxed as per the individual’s tax slab; 20% for income between Rs 5 lakh and Rs 10 lakh, and 30% for income above Rs 10 lakh.
Whereas, STCG tax on equities is fixed at 15% (plus cess). Moreover, the amount of tax applicable on long-term gains, after the benefit of indexation is 20% (plus cess).
Historically, there have been certain instances when over a 3-year or 5-year time period, funds have delivered returns that barely meet the rate of inflation or even less i.e. real returns are negative.
If and when such instances occur in future, an equity investor would be liable to pay tax, whereas a debt investor would not be required to pay tax.
However, under normal circumstances, over the long term (10 years or more) equities have performed well on an inflation-adjusted basis.
Also, due to the risk premium required from equities, over the long-term equities have been able to deliver superior returns as compared to debt investments. Hence, from a long-term investment perspective, equities would still be preferable over debt.
However, in the light of new LTCG tax regulation on equity and equity-oriented mutual funds, in order to optimize the returns, the frequency of buying and selling of equities must be kept at a minimal level.
Consequently, it becomes highly necessary that one invests in a good quality stock which can weather the different market cycles.
Alternatively, one can invest in good diversified equity mutual funds, whereby the individual investor does not have to buy and sell equities, thereby avoiding incurring STT, STCG or LTCG tax.
Buying and selling of securities are done by the mutual fund which does not attract capital gains or transaction-related taxes. The investor would need to pay tax only after exiting from the fund.
However, it would be prudent to evaluate the performance of the portfolio at regular intervals (maybe annual).
If the asset allocation has shifted significantly or a fund is underperforming on a consistent basis or there has been some material change in the fund (fund manager change), then one may consider rebalancing the portfolio or shifting the AUM from the existing underperforming fund to another fund that is expected to perform well. One may incur LTCG tax, but it may still prove to be beneficial over the long term.
