Budget 2018 and LTCG Tax: Simple, concise, actionable insights (Detailed version)


Posted By : Kushal Kothari
Tags :  Tax Budget 2018

The Budget session of the Lok Sabha - that day of the year when your parents, siblings, colleagues and everyone else gets involved in an economic debate with regards to the effects of a 2-hour speech delivered by one of the most, if not the most, important cabinet minister, The Finance Minister. 

Every media house wants to be out with a summary/brief of the highlights of the budget. Though these days, WhatsApp and Facebook beat them hands down in the race to get first to the reader. We thought it is important to share our thoughts with you as well, with a focus on actionable insights we can draw for our users. Today, we focus on only one aspect of the entire budget; One that affects you as a user/reader of this portal the most - The re-introduction of the Long-term Capital Gain Tax or LTCG tax for equity-oriented investments.

 

What is LTCG? - Based on the tenure of your investment, gains from stocks/mutual funds are classified as long-term or short-term capital gains. For debt funds, the threshold for classification as LTCG is 3 years, and for equity funds, it is 1 one year. More about this here.

 

What changes? - The tax on Long-term capital gains has so far been 0% for all equity or equity oriented mutual funds. With the new rule in place, Long-term gains greater than Rs.1 Lakh, will be taxed at 10% starting 1st April 2018. The purchase cost for calculation of gains for taxation will, however, be revised to higher of (1) the actual purchase NAV and (2) the NAV of the scheme as of 31st January 2018. The last provision has been the most amusing part of the announcement, mainly because of being referred to as the 'grandfather' clause, a legal and an accurate term. Do note, these changes come into effect only starting 1st April 2018. We'll see how it impacts your decisions below.

 

How does it affect your portfolio? - There are a couple of ways this impacts your portfolio. We'll start off with some of the straightaway implications, moving on later to the more contentious ones down the ladder.

 

1. More reason to avoid Dividend schemes of Equity funds– So far, the dividends distributed by Equity schemes were tax-free in the hands of the fund house as well as the hands of the investor. However, to ensure parity for growth and dividend schemes, fund houses will have to pay a dividend distribution tax (DDT) of 10% for Equity oriented schemes from 1st April 2018. This change impacts all kinds of dividends schemes of Equity-oriented funds - with the payout as well as reinvestment option.


At Expowealth, we have always held the view that Dividend schemes do not provide many benefits as compared to growth schemes. Now, dividend schemes actually have a negative impact compared to growth schemes!! 


a)    With dividend schemes you’ll end up paying tax (10% DDT) each year on dividends received, rather than letting the investments grow and redeem them at later date. 

b)    Since the tax on dividend is going to be deducted at source by fund house, the 1L exemption of LTCG will not apply to dividend schemes. It is just a no-brainer as to why you should stay away from Dividend schemes all together for equity oriented schemes. 

 

2. SIPs needed for goal planning just shot up – Since the 10% LTCG tax now has to be taken in account for determining the expected value of the investment at the time of redemption, the SIP contribution for equity schemes required to reach the goal just shot up by 10% (ignoring the 1 Lakh deduction). This is a major change for those who meticulously contribute towards investments for defined goals. 

 

3. Friction to rebalancing decisions – One of the unintended by-products of FM’s decision to gather tax on LTCG is the immense complexity it adds to rebalancing decisions for individuals as well as advisors. 

  • Switching to direct schemes – Assume your equity portfolio is in regular schemes and you plan to switch it to direct for long-term benefits. If your portfolio has completed one year, you can choose to switch till 31st Mar 2018, or thereafter

    In case you switch before 31st March 2018 – the good news is that there will be no LTCG tax applicable on the sale. However, the new cost of purchase will be the date of purchase, and not that of 31st January 2018 (as accorded by the budget). As such, this is a very immaterial change, whose effects will be minuscule, and that too long in the future when you actually have to redeem the investments. The effect of a lower purchase cost will magnify in case you switch when the fund is at a significantly lower NAV as compared to 31st Jan 2018. Hence, it would be prudent to make the switch before the levels hit too low, before 31st March 2018. In case you switch at a NAV higher than that of 31st Jan 2018, it’ll actually be much more beneficial. Though in our opinion, the likelihood of that happening is very less before 31st March 2018.
     
  • Rebalancing equity portfolio – One of the most important aspect at the time of re-balancing is to account for STCG. With the STCG rate at 15% and LTCG rate at 10% (with 1L benefit), the decision to rebalance got slightly easier while also slightly complex. Easier because the gap between the two rates has narrowed and hence the importance of tax consideration on rebalancing reduces. However, what that impact is and how to take that into account is now much more complex due to the 1 lakh deduction applicable on LTCG.
     

4. Other schemes to be relatively more attractive - Many other investment products, which now have better tax treatment (or relatively less bad treatment), now get even more attractive.

  • NPS (National Pension Scheme)– One of the biggest argument in the comparison between NPS and Mutual Funds for retirement planning has been the differential tax treatment of the two. MFs so far have got scot-free due to zero LTCG tax. However, NPS has only 40% corpus as tax-free at maturity. While we can still argue that there are other draconian clauses about compulsory annuity purchase and less competitive performance of NPS schemes, the argument for NPS got slightly stronger due to equity MFs becoming relatively less attractive. 
     
  • Thematic portfolio investing / PMS – These guys just got a bit complex. One of the important aspects of Thematic portfolio and PMS investing is the ability to rebalance the stocks at will. LTCG so far didn’t play a role as it didn’t matter as long as long as you had completed one year of investment. Now, there is friction for them to rebalance just as we described in an earlier point. More so, since many PMS investment schemes take a 10 – 20% cut of the profit, either they will have to take a proportional hit of the LTCG tax, or they will have to pass the tax completely to the customer (taking the profit sharing fees pre-tax), which will end up making the service less attractive to the end investor. 
     
  • The ELSS vs ULIPS vs PPF argument – The comparison of three of the most prominent tax saving instruments tilts in the favour of the latter, slightly. At Expowealth we’ve always been against ULIPS - The fundamental problem with ULIPs. With ELSS and PPF, while it eventually comes down to the risk appetite of the investor, the case for PPF from the tax perspective just got stronger. PPF attract absolutely no tax at maturity or from the interest gain. ELSS, however, will now attract a 10% LTCG tax, which so far has not been the case.

 

5. Opportunity for financial engineering – The Budget gives leeway to the investor, in that there’s a 1L deduction for LTCG every year. This makes things very interesting. Bear with us as this may get a little dense.

If you are a buy and hold kind of investor, it opens up a loophole to save tax. Basically, assume you are invested in an equity scheme, say MOST 35 - A Multicap scheme. Instead of not selling the scheme at all, you will find it beneficial to churn it into a similar scheme, say MOST focused 25 - Another diversified equity scheme. You can do these switches such that you always end up getting 1 lakh in LTCG every year (yet ensuring you don’t have to pay any exit load). This way, you’d end saving a whole lot of tax when you actually redeem the investment. The average purchase cost at the time of selling will be much higher than what it would have been had you not churned at all.

Of course, churning your portfolio just for the sake of saving tax can have negative effects if it causes your overall asset allocation to deviate from the target one. Also, it would be quite a complicated and tedious process. All we want to say is that Budget 2018 has just added one more loophole for highly motivated individuals to save some tax (like bonus stripping, dividend re-investment and likewise)

 

6. Not much of an Arbitrage (schemes) -  This in our opinion is a direct casualty of the introduction of LTCG on equity schemes. For many years, the selling pitch of arbitrage scheme has been "get money market returns with zero tax after 1 year". This changes significantly now. Let's look how. Consider the tax treatment of Arbitrage schemes vs Debt schemes in the two tables below:I

Before Budget 2018

Scheme

Holding for <1Year

Held for 1-3 years

Held > 3 years

Arbitrage

15%

0%

0%

Liquid/Money market

30% (max)

30% (max)

20% (with indexation)

 

After Budget 2018

Scheme

Holding for <1Year

Held for 1-3 years

Held > 3 years

Arbitrage

15%

10%

10%

Liquid/Money market

30% (max)

30% (max)

20% (with indexation)

 

As you can see, the impact is the highest for holding period >3Years. Let us understand with an example of impact due to the change in LTCG. Let’s assume you bought 10L in a liquid (arbitrage) fund as of 1st Feb 2018. Assume the inflation for next three years at 5% and returns of arbitrage schemes (and liquid schemes) at 7%.

On 1st Feb 2021 -

Value of Investment after 3 years = 10L * (1.07 ^ 3) = 12.25L

Cost Indexation = 1.05 ^ 3 = 1.157

Indexed purchase cost = 10L * 1.157 = 11.57L

 

LTCG = 12.25L – 10L = 2,25,000

LTCG after Indexation = 12.25L – 11.57L = 68,000

 

Illustration of LTCG Tax for Arbitrage and Liquid Schemes

Scheme

Holding just less than 3 years

Held just greater than 3 years

Arbitrage

22,500 (10%)

22,500 (10%)

Liquid/Money market

67,500 (30%)

13,600 (20% with indexation)

 

There is one caveat though. There is an exemption of 1L for LTCG gains. This introduces an element of tax harvesting in which if you are able to manage your sell orders to keep LTCG under 1L, arbitrage schemes will still be quite attractive. Having run all permutations on our end, here is our take on arbitrage schemes:

  1. If you intend to use proceeds from arbitrage schemes in less than 3 years, they still make sense from a tax point of view. But do note, these are not the same as liquid schemes.
     
  2. If you are a high net-worth individual investing in these schemes for a longer horizon, we’d suggest staying away from these schemes. The benefit of indexation in liquid funds will compound over a period of time to give significant benefits in the long run as compared to arbitrage schemes. In the example above

Horizon

Arbitrage LTCG Tax

Liquid LTCG Tax

Difference

3 Yr

22,500

13600

8,900

7Yr

60000

38000

22000

12Yr

1,25,000

90000

35000

 

We hope we have been able to add value to our investors to understand the impact of the Budget on your investment better. Feel free to reach out to us for any suggestions/queries.

 

Happy Investing!