The Union Budget of 2018-19 has changed the tax treatment of all equity and equity-oriented mutual funds. This change was by way of a 10% tax imposed on any long-term capital gain (LTCG) exceeding Rs 1 lakh a year. Equity mutual funds were exempt from the LTCG tax earlier. Hence, this change has been viewed by investors with some worry. While any tax has the potential to impact the returns of equity fund investors, investors should not let them alter their long-term financial plans. Here’s why.
The new LTCG tax is applicable to all equity-oriented mutual funds which hold more than 65% of their assets in equities. The LTCG levy arises when investments held for over a year in the case of equities are sold. As you may be aware, the short-term tax on equity holdings for less than a year continues to be 15.6%. The new LTCG tax of 10% (or 10.4% including the health and education cess) is applicable from April 1, 2018.
Any redemption of units from equity-oriented funds until March 31, 2018, were exempt from the tax. Moreover, its immediate impact on investor returns has been cushioned by grandfathering or exempting any gains that have accrued until January 31, 2018.
Mutual fund investors should note that the LTCG will be calculated without the benefit of indexation. This means investors will not be able to take the advantage of adjusting the acquisition cost of the investment to the cost inflation index.
Since the announcement of the LTCG tax, many investors are perplexed about its calculation and how it will ultimately impact their returns. We believe that rather than shying away from investing in equity mutual funds, it is imperative that investors fully understand the new tax provision.
The LTCG tax is a reality, and pragmatic investors will know that they need to continue to focus on the big picture of wealth creation to meet their long-term financial goals.
LTCG will be calculated by deducting the cost of acquisition from selling price. Now, the cost of acquisition is considered as higher of: Actual cost, and Lower of: either Fair market value (highest value traded on 31st January 2018) or Selling price on/ after April 1st, 2018.
Do remember that long-term capital loss will be allowed to be set-off against any other LTCG and unabsorbed loss can be carried forward to subsequent eight years for set-off against LTCG.
No alternative to equity MFs
Equity markets may be volatile in the short term but the fact is that this volatility reduces over time. This makes equities the best asset class on returns in the long-term as compared to other asset classes. This picture does not change even after the introduction of the LTCG tax.
If an investor invests Rs 5 lakh in an equity fund that grows at 15% CAGR, the impact of the tax on overall return will be marginal. Investors must learn to ignore the quantum of tax outflow. The post-tax return on long-term investments in equity oriented mutual funds is intact even after the tax.
If you invest Rs 10 lakh in an equity fund that gives you a 15% compounded return, you will earn Rs 30.5 lakh after 10 years if there is no LTCG tax while you will get Rs 27.5 lakh if there is a 10% LTCG tax. After 20 years, your MF returns without LTCG tax will be Rs 1.5 crore without LTCG tax while it will be Rs 1.4 crore with LTCG tax. As you can see, the difference between the two returns over long periods of investment is minuscule.
In conclusion, while the LTCG tax will bring down their returns from equity funds because earlier there was no tax, investors must know that the impact of the tax on returns will
be marginal in the long term as equities continue to offer superior returns among all other asset classes on a long-term horizon. The higher your holding period for the investment, the lower is the impact on the CAGR due to this tax, other things remaining same.
*(Author is Founder and CEO of Right Horizons. An ICFAI Business School alumnus, Mr. Rego worked at Wipro Tech for 7 years, before he plunged into the entrepreneurial journey. He founded Right Horizons, a financial planning and advisory company, in 2003, a time when wealth management was at very nascent stage in India. His objective; help others achieve their financial goals. Today under his stewardship, Right Horizons manages more than Rs.800 crores of AUM and created a client base of +1000 customers across pan India.)