The change in long-term capital gains (LTCG) tax on equity coupled to the related tax on equity-oriented funds could lead to significant changes in investment strategies for investors. To recap, the tax-meter starts ticking only from a base date of January 31, 2018 due to the ‘grandfathering’ concept. The price of a stock on January 31, 2018 is used for calculating LTCG. (A more complicated formula is used for mutual funds where systematic investment plans (SIPs) complicate the question of acquisition price).
The tax rate itself is moderate at 10 per cent. But there is no indexation for long-term gains. Comparing short-term gains taxes to LTCG, the difference will be five percentage points from 2018-19. The short-term capital gains (STCG) tax will continue to be taxed at 15 per cent (plus cesses). The direct equity investor has an incentive to hold stocks beyond 12 months. But it isn't as much of an incentive as earlier. Also, the lack of indexation reduces the incentive to hold for the very long-term.
The lack of indexation makes the new tax regime unfair to equity investors compared to those who hold other long-term assets. Indexation offers a huge incentive to hold real estate, jewellery and debt funds for the long-term. Over say, a period of three-six years or longer, even moderate indexation rates will compound to excellent tax savings.
Suppose an equity investor sees the same gain over the same period. A stock bought at Rs 100 climbs to Rs 196 over 10 years. The 10 per cent tax is levied without indexation. Hence, the equity investor would pay Rs 9.6 tax on a sale. Given the power of compounding, the longer an equity asset is held, the more the lack of indexation hurts the equity investor.
This ‘tax-efficiency comparison’ must also be made by an investor when choosing between a debt-fund and an equity fund. Equity funds also don't receive indexation benefits (the tax is deducted by the fund and reflects on the net asset value) while debt funds do have the indexation benefit. So the power of compounded indexation narrows any positive difference in returns for equity.
Post-tax returns from debt funds can therefore, outperform that from equity, if there's a period when there is a burst of high inflation (increasing the indexation rate and thus lowering the tax incidence on debt returns). Incidentally, equity linked savings schemes also become less attractive since these are also subject to LTCG without indexation and there's a three-year lock-in. Unit-linked insurance plans (Ulips) may find more takers on the other hand since these instruments are not subject to LTCG. But there's a five year lock-in period for Ulips.
This change in the tax system could also hurt hybrid funds and arbitrage funds as well since those will also be hit by LTCG without indexation. The portfolio mix usually means that arbitrage funds or hybrids don't, in the long term, generate the same level of returns as pure equity. So these segments of the mutual fund industry could end up with far fewer takers.
Of course, equity does in general give higher returns than debt. But that return would really have to be much higher to make it worth holding equity over long periods if this indexation anomaly remains. In time, this could mean investors cutting their exposure to equity-oriented mutual funds, as well as being reluctant to park money directly in equity.
This could mean household savings in particular could seek other investment avenues as the new tax becomes applicable. Over the next year or so, we may see more in the way of money flows into two investment staples, gold and real estate. Gold is already seeing some revival in interest. Debt is less likely to look attractive since inflation expectations are high and debt funds perform badly when inflation rises.