Re-Introduction of Long Term Capital Gains Tax

India's 2018 Budget delivered by Finance Minister, Mr. Arun Jaitley proposed return of long-term capital gains tax of 10% on stocks and equity mutual funds exceeding Rs. 1 lakh within a financial year without allowing any benefit of indexation. In 2004, the government had abolished long-term capital gains tax on equities held over a year.

However, as per the Budget 2018, all gains until 31st January, 2018 will be grandfathered. This implies that you will not be taxed on any gains that you have already accumulated up until 31st January, 2018. For investors, the fund values on 31st January 2018 shall become the base value or cost of investment for calculation of future gains for taxation purpose.

More recently, on 4th February, 2018, the Central Board of Direct Taxes (CBDT) clarified that the new long term capital gains tax will be applicable only for sales on or after 1st April, 2018. The long-term capital gains tax exemption will continue for any sale between 1st February and 31st March, 2018 as per current taxation policies. To summarize, there is no change in the long term capital gains tax exemption for the financial year 2017-18.

Introduction of Dividend Distribution Tax in Equity Mutual Funds

The budget 2018 has also proposed levying 10% Dividend Distribution Tax on dividends distributed by equity oriented mutual funds from 1st April 2018 onwards. The equity-oriented funds comprise diversified equity funds, balanced funds, equity income funds and arbitrage funds.

This tax shall be paid by the mutual fund from the declared dividend and subsequently, the dividend shall remain tax free in the hands of the investor. This shall result in lower dividend payout to the investor. For example, till now, if the mutual fund declared a dividend of Rs.100/-, entire amount was paid to the investor without any deduction and this amount received was completely tax free for the investor. Under the new tax laws, when a fund shall declare a dividend of Rs.100/-, Rs.10/- shall be paid by the fund as 10% tax to the government and Rs.90/- shall be paid to the investor as dividend, thus reducing his dividend income. This dividend of Rs.90/- shall be tax free for the investor.

Returns from Growth and Dividend Option to Vary

Till now, neither the fund nor the investor was levied tax on the dividends. Hence, the returns of growth and dividend option of a scheme were similar. From now onwards, the returns from growth option of equity funds shall be higher than the dividend option as the dividends shall be charged 10% tax. The 1 lakh capital gains exemption from tax shall mean that the investors shall be paying lower tax if they choose growth option over dividend option.

Our View

Like any tax, coming back of Long Term Capital Gains Tax (LTCG) or Dividend Distribution Tax (DDT) is negative news for the investors. LTCG or DDT shall reduce the funds in the hands of investors. Since these taxes are here to stay, we shall suggest the investors to moderate their returns expectations from equity investments. Instead of expecting 15-16% returns, they should now target 13-14% returns from their investments over long term.

Revising Financial Goals

Investors who have planned long-term financial goals will have to revise their returns expectations. As the rate of return expectations are reduced, a higher allocation of funds to meet the planned financial goals shall be required.

Less Portfolio Churning

Till now, as the taxation on gains after one year of investment was zero, it was possible to frequently redeem one fund and invest in another potentially higher performing fund. But as the tax shall be applicable on gains even after one year of investment, every sale shall take away some gains from the fund and hence, the amount left to reinvest shall be lesser than the redeemed fund. This shall reduce the overall fund value over a period of time. To avoid such costs on every fund switch, it shall be important to choose consistently performing funds over cyclical funds so that frequent churning is not required. This shall particularly be true for high networth investors whose yearly capital gain on churned investment is more than 1 lakh exemption limit.

Reduction in Monthly Income

Investors who are seeking regular income in form of dividends from mutual funds should either increase their investments to maintain the current income or lower their income expectations by 10%. They may be better off by switching their funds from dividend option to growth option and starting a Systematic Withdrawal Plan (SWP) for regular income from funds. Through gains made in growth option, they shall be able to take benefit of 1 lakh exemption from tax. That means at least on 1 lakh gains made in a year, they will not have to pay 10% tax which shall result in savings of Rs.10,000 every year.

Conclusion

Let’s accept taxes as they come by and plan our investments accordingly to minimise their impact on our financial well-being. Switching from dividend to growth option in funds, making higher allocation to financial goals, choosing diversified and consistently performing funds to reduce periodic churn, taking benefit of 1 lakh exemption in a year are some of the ways by which investors can reduce taxation and fulfil their goals with peace of mind in the times to come.

If you have any further concern or query regarding your investments or tax implications, please speak to your financial advisor or write back to pawan@investguru.in and I shall be happy to reply.

As always, your views and feedback on the above are welcome.

Happy Investing!

Pawan Agrawal is the founder and managing partner of Investguru. You may reach him at pawan@investguru.in.