Bursting some myths about LTCG tax – Part 1
“There is nothing more deceptive than an obvious fact.” ―Arthur Conan Doyle
In the latest budget, Finance Minister Arun Jaitley, reintroduced Long-term capital gain tax for equity investments starting 1st April 2018. After the imposition of LTCG tax, there was lot of confusion and discussion. I tried to introduce the concept of LTCG tax on equities in my earlier post here.
Now, I am no tax expert and rely mainly on my calculations to make sense of the changes. So, the calculations are reflections of my understanding. One of the things many people asked me was whether LTCG tax with indexation benefit would have been better. Had the tax rate been the same (LTCG tax @10% with indexation benefit), indexation benefit would have definitely reduced the tax burden.
However, whenever the indexation benefit is given, the capital gain tax rate is higher @ 20%. Furthermore, the holding period requirement for qualifying for long-term gain is also higher (3 year for debt mutual funds). In a series of articles, I will share some of my thoughts on LTCG tax. Here, I try to answer whether LTCG tax @10% is better or worse than LTCG tax @20% with indexation benefits.
Myth 1: LTCG tax @20% with indexation benefit would have been better than flat LTCG tax @10%
Now many people who have paid LTCG tax on debt mutual funds have noticed that effective tax rate after indexation is quite low. For example,
Invested amount = INR 100 in debt mutual fund (assume 8% annualized return)
Inflation = 6%
Portfolio value after 3 year = INR 125.97
Indexed cost = 119.10
Long-term capital gain = 125.97 – 119.10 = 6.87
LTCG tax @20% = 6.87*0.20 = 1.37
Effective LTCG tax rate = 1.37/25.97 = 5.3%
The above example is quite close to real life experience in last few years. However, when we look at equity, the experience could have been different due to following reason:
- Smaller the difference in asset class return and inflation, higher is the benefit of indexation. If return from asset class is equal to the rate of inflation, the real capital gain is zero and the capital gain tax amount would be zero.
- As the gap between the return from asset class and inflation increases, the indexation benefits decrease. As a result, effective tax rate starts to increase
- Now debt mutual funds delver 7-9% and due to indexation benefit, the effective LTCG tax rate comes out to be around 5%.
- The same cannot be said about equity investments as the return from equities could be between 10-15%.
- For example, if someone invests 100,000 in equity (12% return), his portfolio would be 140493 after 3 years. The LTCG tax @10% (without considering any exemption) will be 4049. If we assume inflation to be 6%, LTCG tax @20% with indexation benefit will be 4278. Clearly, here the LTCG tax amount is lower when LTCG tax is 10%.
Finally to summarise key points on LTCG tax for equities:
- Lower holding period for LTCG applicability, exemption limit of 100000 and a lower tax rate of 10% means LTCG tax on equity is still lower compared to other asset classes.
- Unlike debt investments where gap between asset class return and inflation is less, the difference between equity return and inflation is more than 5%. In such a scenario, indexation benefit is less and lower tax rate is more beneficial.
- Given there is an exemption limit of 1 lacs, investors should look to partially book profit to the tune of 1lacs every year. Remember, LTCG tax is payable only when you sell. One should look to defer the LTCG tax by increasing holding period of equity mutual funds. One should not get confuse between the point above and increasing holding period. Both these steps will help in reducing LTCG tax on equity.
Disclaimer: The above content is just for information and should not be construed as an offer to buy or sell or recommendation. Contact your financial advisor for guidance on any investment related query.
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