From April 1st 2018, long term capital gains on stocks and equity mutual funds over Rs. one lakh have been taxed at the rate of 10% (plus 4% education cess) without indexation benefits.
P V Subramanyam of subramoney recently pointed out to me that we will be paying more tax on equity mutual fund gains in a few years than debt (or non-equity MF) gains. He suggested that I compute this scenario to know when this would happen. Long-term readers may know that I have often made calculators suggested by Subra, culminating in our book, You can be rich too with goal-based investing. The calculators part of this book is now available on SEBI’s investor education website.
Subra’s logic is as follows. The tax rate on equity mutual funds is a flat 10%. Soon the Rs. one lakh tax-free limit would be breached, and the tax will kick in. Non-equity mutual funds (any fund that does not invest in 65% or more of Indian stocks or Indian ETFs) benefit from indexation.
That is, the capital gain will not be computed as the sale price minus the purchase price (as is the case for equity funds). It is computed as the sale price minus the indexed purchase price.
That is, we inflate the purchase price using the cost inflation indexation to the year of sale. In other words, we ask if we had purchased those non-equity funds units today (when we are going to sell), how much would the purchase price increase due to inflation? A detailed example is here: Taxation of international mutual funds explained with an example.
Subra argues that indexation-benefit can be immense over time. Even though the tax rate of non-equity funds is 20% (plus a 4% education cess), the tax is applied to the indexed capital gain. Therefore the effective tax rate reduces well below 20%.
If we assume equity outperforms debt over the long term, the tax on equity can be higher than on non-equity funds.
Consider an Rs. 1 lakh purchase in equity and non-equity funds simultaneously. Assume that the equity return is 10% and the non-equity fund return is 7% (we shall assume it is a debt fund). We also assume that the cost inflation increases yearly at an average rate of about 5%.
For these assumptions, after 12 years, the tax on equity is higher than the tax on the debt fund, as shown below. The chart starts from three years as we compare equity LTCG taxation with non-equity LTCG taxation.
This is why Subra argues that we need indexation benefits for equity as well. The Rs. one lakh tax-free limit will not matter much if our gains are much higher. Over time the tax on this will increase compared to the non-equity LTCG tax, which comes with indexation benefits. Let us hope the government introduces indexation benefits for equity LTCG as well.
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Dr M. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. He has over nine years of experience publishing news analysis, research and financial product development. Connect with him via Twitter or Linkedin or YouTube. Pattabiraman has co-authored three print books: (1) You can be rich too with goal-based investing (CNBC TV18) for DIY investors. (2) Gamechanger for young earners. (3) Chinchu Gets a Superpower! for kids. He has also written seven other free e-books on various money management topics. He is a patron and co-founder of “Fee-only India,” an organisation for promoting unbiased, commission-free investment advice.
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