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RGESS may not be perfect, but it’s good enough

The Rajiv Gandhi Equity Savings Scheme has been operationalised. It’s a modest tax-saver and a little complex to use, but it could do the job of introducing first-timers to equity investing

Back in March this year, when the Rajiv Gandhi Equity Scheme (RGESS) was announced in the Union Budget, I had written that if operationalised properly, the RGESS could prove to be revolutionary. Now that it has finally gotten off the ground, has that hope been realised? Well, it’s not quite a revolution, but is still a useful investment avenue to have. Moreover, I rather think that this is but a first step in particular direction. The RGESS is very different from any other tax-break investment scheme the government has ever launched and after some real world experience, it may get tweaked to become more useful in the years to come.

Let’s look at the details. The original description of the RGESS that Mr Mukherjee gave in his speech was “To encourage flow of savings in financial instruments and improve the depth of domestic capital market, it is proposed to introduce a new scheme called Rajiv Gandhi Equity Savings Scheme. The scheme would allow for income tax deduction of 50 per cent to new retail investors, who invest up to Rs 50,000 directly in equities and whose annual income is below Rs 10 lakh. The scheme will have a lock-in period of 3 years”.

All this still holds but there have been some important modifications that will make a difference to investors. Most importantly, the range of investments allowed has been narrowed within the equity universe but broadened in the direction of mutual funds. Firstly, the government has limited the scheme only to large companies. Instead of the stock of any and every company, RGESS investments can only be made in companies that are in one of these sets: the BSE 100 index; NSE’s CNX 100 index; public sector Navratnas, Maharatnas and Miniratnas; and IPOs of public sector units that have sales of at least Rs 4,000 crore in the preceding three years. Additionally, Exchange Traded Funds (ETFs) and mutual funds whose underlying investments consists only of stocks that are in the above eligibility lists will also be eligible.

Evidently, the idea is to limit investments to only large companies, whose stocks are generally more stable than that of smaller companies. This will limit the risk to the first-timers who will invest in the RGESS.

Is this an assumption, that larger companies’ stock prices are more stable? It is, in terms of broad averages but there are a plenty of examples of rather frightening exceptions. For example, the market prices of a number of infrastructure companies that were among the 100 which largest fell by massive margins during the 2008-09 market crash. And when the markets came back up again in May 2009, these stocks never came again. There are scary examples of formerly large companies like Reliance Communications and DLF down to1/10th and 1/5th of their old values.

Since the RGESS has a three year lock-in, what would an investor in such stocks do? The solution that the finance ministry has formulated for this is the RGESS’ most innovative feature, and one which I hope will eventually be applied to other tax-break investments—the RGESS’s lock-in is not for the actual investments but for the amount invested. For one year after the initial investment, the lock-in is total but after that, investors can execute trades in their RGESS securities, provided that the amount equal to at least the initial investment stays within the set of RGESS-eligible securities.

The ministry’s notification says this, “The general principle under which trading is allowed is that whatever is the value of stocks / units sold by the investor from the RGESS portfolio, RGESS compliant securities of at least the same value are credited back into the account subsequently. However, the investor is allowed to take benefits of the appreciation of his RGESS portfolio, provided its value, as on the previous day of trading, remains above the investment for which they have claimed income tax benefit”.

This is a completely new kind of freedom for any tax-exempt investment so it’ll take a little time for its implications to sink in. Here’s an example. Suppose you invest Rs 50,000 under RGESS. For one year, you can’t do anything to the investment whether it rises or falls. After a year, let’s say the value of the investments have risen to Rs 60,000. Now, if you like you can just sell shares or funds worth up to Rs 10,000 and realise that as tax-free profits. Note that these profits are tax-free not because of this scheme but because they are anyway long-term capital gains.

As for the remaining Rs 50,000, you can realise that too but the proceeds must be re-invested in RGESS-eligible securities. You just have to make sure that for the remaining two years, the value of the residual RGESS portfolio remains at least the amount you claimed tax benefits on, on at least 270 days. This part is a little complicated but the complications are probably unavoidable.

The only downside of the RGESS is that it can just be used once in a lifetime and that too if you have never made equity investments earlier. The tax savings will effectively be just Rs 5,000. It’s your call whether opening a depository account and all the rest of it is worth Rs 5,000. However, as a small benefit that might help you get initiated and curious about equity and equity-based investments, it’s not bad. At least, for the first time in India, there’s a tax-saving benefit that can only be derived by opening a depository account and getting initiated into equities.

I hope that in the years to come, the government extends the one-time limit in the RGESS. Even if it can’t be made permanent like 80C or other tax-breaks perhaps it can be extended to three or five years. People get initiated into something and gradually get used to it. One single year may not be enough for the government’s goal to of establishing an equity investment culture to be met.