The proposal to tax long-term capital gains from equity funds has miffed investors. Their returns will now be lower than anticipated.
This could change the way people prefer to invest their savings. For instance, equity-linked savings schemes (ELSS) could lose the tax-free status that made them among the favoured options for investors looking to save tax.
Also, given that equity funds will not be allowed indexation benefit, the tax disparity between equity and debt schemes has narrowed, making debt funds and FMPs more attractive now.
ELSS can still yield higher post-tax returns
Even after 10% tax, ELSS funds retain high wealth generating ability.
Data as on 6 feb 2018 Source: Return data from Value Research
Don’t shun ELSS
The tax on LTCG will make tax-saving options such as the Public Provident Fund (PPF) and Ulips more tax-efficient than ELSS funds. These will continue to be taxfree while the gains from ELSS funds will be taxed at 10%. But experts say investors should not shun ELSS because of the new tax. The different nature of these investing avenues means each has a different role to play in an investor’s portfolio. Being pure equity based instruments, ELSS funds have the potential to generate higher returns, making them an ideal long-term investment, irrespective of the new tax. Rohit Shah, Founder and CEO, Getting You Rich, asserts, “For aggressive investors, ELSS still remains lucrative as the post-tax return will be greater than PPF and high cost 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 underperforming. In case of underperformance 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 for long-term wealth creation,” adds Shah. Besides, ELSS still has the shortest lock-in period of three years among all instruments under 80C, points out Amol Joshi, Founder, PlanRupee Investment Services.
Avoid Ulips, insurance policies
After the Budget announced the tax on LTCG, insurance companies have started giving ads highlighting the tax-free returns from insurance policies and Ulips. However, financial planners advise against investing in these plans. “We prefer to recommend investment products which give taxable returns but perform better than products which are tax free but give low returns. Mutual funds remain our first choice, not tax-free insurance policies,” says Abhinav Angirish, Managing Director, Abchlor Investment Advisors. In any case, insurance and investments should not be combined in one product. A term plan serves the objective of protection better and mutual funds generate higher returns.
If you want to save tax under Sec 80C, a combination of ELSS and PPF is perhaps the best option. While ELSS generate higher returns, PPF provide a stable foundation with assured income. “Ideally, investors should have a mix of ELSS and PPF, and not use one instead of the other. This fetches the investor three benefits under one basket—asset allocation afforded by mix of equity and debt, safety of a governmentbacked vehicle and pure growth of an equity offering,” says Joshi.
Arbitrage for short-term
Equity arbitrage funds, a sub-category that offers ‘debt like return and equity like taxation benefits’, have also been hit by the new tax. The returns from equity arbitrage funds are comparable with those of short-term and ultra-short term debt funds. Investors, especially HNIs, used to park their short-term funds in these funds to gain from the tax advantage. While debt fund investors were forced to pay a dividend distribution tax of 28% (ie 25% plus 12% surcharge), there was no dividend distribution tax (DDT) here.
Despite the recent taxes, equity arbitrage funds are the best bet for parking money for 6-12 months
* 25% + 12% Surcharge + 4% cess
# 30% tax + 15% surcharge + 4% cess for upto 3 years; 20% (with indexation) + 4% cess after that. If we assume 8% returns from debt funds and 5% inflation rate, inflation adjusted tax will be only 20.8% of 3% (ie 0.624%). and on the original gain of 8%, the effective tax rate works out as 7.8%. Data as on 5 Feb 2018 : Source Value Research
Similarly LTCG were tax free here after a year of holding, while debt fund investors paid 20% tax even after holding for three years. Though equity funds will now be subjected to LTCG tax and DDT, experts say the arbitrage funds are still the best option to park short-term funds. “Though the sheen has reduced, equity arbitrage funds continue to generate better post-tax returns than other alternatives,” says Ashish Shanker, Head – Investment Advisory, Motilal Oswal Private Wealth Management.
The tax rate is still attractive for equity arbitrage funds. While debt funds investors pay a total DDT of 29.12% after 1 April, it is only 10.4% for equity arbitrage funds. Similarly, the tax advantage is huge for the 1-3 years holding period also. “The tax arbitrage differential will come down, but equity arbitrage funds will still remain a good option for short-term investments,” says Raghvendra Nath, MD, Ladderup Wealth Management. Besides, the sudden increase in stock market volatility, triggered by the imposition of the LTCG tax and DDT on equities, is good news for arbitrage funds. The arbitrage opportunity is greater during periods of increased volatility. “Usually, carry costs are low when the market is extremely bullish. Risk premiums will be higher in volatile periods like this,” says Nath.
However, the arbitrage opportunity may come down if the correction continues for very long and investor interest in the market wanes. In arbitrage funds, the dividend option makes more sense. The tax rate on shortterm capital gains is 15% while dividends will be taxed at 10%. “Since there is a tax advantage of 5% in the first year, the dividend option is better,” says Nath. Arbitrage funds make money by buying and selling in different market simultaneously to corner the price difference. Their risk profile is comparable to that of debt funds. However, these funds can be very volatile in the short term (less than three months). “Since NAVs can fluctuate wildly for short holding periods, the ideal investment horizon for this segment is 6-12 months,” says Shanker.
Time to buy debt funds
Retail investors in mutual funds focus mostly on equity schemes, while debt funds are generally ignored. One reason for this is the tax treatment of returns. Short-term gains from debt funds are added to your income and taxed at normal rates and longterm gains are taxed at 20% after indexation. Though equity funds still retain the upper hand (the minimum holding period for long-term gains is one year compared with three years for debt schemes), the 10% tax on long-term gains from equity funds has reduced the tax disparity.
How debt funds gain from indexation
Adjusting for infl ation during holding period lowers the effective capital gains and the tax outgo
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,” says Kunal Bajaj, CEO, Clearfunds. Experts say investors should integrate bond funds in their portfolio and use them in conjunction with equity funds for goal planning. Bajaj asserts that the utility of bond funds is more evident if investors take a holistic view of their mutual fund portfolio. “Bond funds when used in isolation do not offer high returns, but they protect the downside in a portfolio,” says Bajaj.