How to counter Long Term Capital Gain Tax

Finally the biggest fears of equity investors has become a reality now. Much speculated long term-capital gains (LTCG) tax on equities is back. The proposal of LTCG made by the Finance Minister on 1 February 2018 rattled the stock market, sending the markets on a downward spiral. The Sensex is almost 2,000 points down since the announcement. Although grandfathering of capital gains till 31 Jan 2018 i.e. LTCG earned up to this date won’t be subject to tax—prevented the market from plummeting on Budget day, but it could not rein in the fall the day after as there are other negatives like continuation of STT, not providing indexation benefit to long-term equity investors, etc. later will keep the sentiments down for the time being.

1. Impact of LTCG

As proposed the LTCG tax is 10% without indexation for equities. Currently for Debt funds there is 20% LTCG tax with indexation benefit.

If we assume a return of 10% from both equity and debt funds and 5% inflation.

The effective return post LTCG tax on debt funds works out to be 9% {10- (10-5)*20%}.

And for equity also it will be 9% (10-1)%.

So if the returns are less than 10% then indexation benefits (assuming 5% inflation) will reduce tax liability and for more than 10% returns the 10% straight tax (without indexation) improves the returns for the investors.

Normally we expect 10%+ returns in the equities so indexation may not be very helpful in that case. However there is also STT (Securities transaction tax) of 0.1% which will reduce the net returns a little bit.

2. Who will be impacted?

       i.          (i) Individual investors who are investing in Equities or Equity Mutual funds have to pay the   tax.

 (ii) Being trustee of investors’ money, Domestic mutual funds/Insurance companies, don’t   have to pay LTCG tax so for them there will be no impact. Only the investor when he   redeems need to pay the tax.

(iii) FIIs i.e. foreign institutional investors will have to pay tax on their trades which will push up their costs. Also, though the grandfathering clause provides some relief, it increase their operational costs due to tax compliances.

3. What will be the impact on Market?

Now after the introduction of LTCG tax, the difference between the STCG and LTCG is only 5% now. Due to this few investors may wait for a year to sell. Investment decisions will now be based on the market situation and not based on tax concerns as the 5% difference between LTCG and STCG, will not be so lucrative for investors to wait for an entire year just to avail of this extra  tax benefits. Earlier even if they wanted to book profits they normally use to stay invested for minimum one year just to get the gains tax free now this will not be the case.

This will result into more volatility in the stock market.

4. So what can an investor do?

Government has proposed that LTCG on equities will be tax free up to ₹1 lakh per financial year. So for small investors it may not impact much. For example if an investor is investing 5000 monthly SIP and expected return is 12% the total capital gain would be approximate 1.12 lakhs after five years. So by taking some redemptions in between he may not be required to pay any tax. Or for one time investor who has invested 8 lakhs and with 12% returns it comes just 96000 so no need to pay tax on the entire gain.

With a 10% Dividend Distribution Tax (DDT) being introduced on Equity Mutual Funds only, the overall outgo in hand of investor will reduce marginally. However the MF dividend remains tax free in the hands of the investor. This is specifically for retirees. So it is better to avoid dividend option in mutual funds.

However for large investors there will be an impact which can be reduced to some extent by constantly booking profits on regular intervals.

Since we can’t carry forward the ₹1 lakh sum—hence we cannot claim ₹10 lakh exemption over a 10 year period. So, we will have to 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.

So for very small investors there may not be any effect if they book profit time to time and for large investors they may have to pay some tax and hence to achieve their goals they may be required to increase the investment amount by 10-12% so as to achieve their pre decided goals.

To Conclude

It is more important than ever to stop churning the portfolio of MF in the name of “More Returns” or “Asset Allocation”. as we may save the 1% exit load but will incur the 10% LTCG., so we should redeem only to book profit when it is reaching 1 lakh limit or the scheme is not doing good.

Remember, the risk is in our investment strategy not in the market. If we have put together an investment for a Financial Goal no other asset class except equities (even after LTCG) will allow us to achieve it.

Finally we must consult our advisor to define priorities and risk profile before starting investments. It’s even more important with the new tax regime in place.