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Hijacked by tax planning

Who said tax laws are fair? They are only meant to maximise revenues. So don't waste time chasing tax loopholes

Recent reports suggesting that the budget could re-classify arbitrage funds as debt funds, for the purpose of taxation, seem to have sent distributors and investors into a tizzy.

Since last July, when the FM suddenly decided to hike short term capital gains tax on debt funds, arbitrage funds have become a hugely popular category, but more as a tax planning vehicle than as a good supplement to the fixed income portfolio.

If you bought arbitrage funds mainly for tax planning, you have good reason to worry. In the past, whenever the fund industry has discovered any loophole in tax laws and tailored its products to exploit it, the tax department has been quick to discover the loophole and plug it.

Loopholes plugged
Only last July, we saw the FM put a stop, with retrospective amendments, to the 366 and 377-day Fixed Maturity Plans which offered a double-indexation benefit on capital gains.

A few years ago, dividend and bonus stripping in mutual funds was all the rage, with many investors using it to show a short term capital loss on their units, which could be set off against their future gains. This loophole was plugged through an amendment which made it compulsory (if one wants to claim a loss) for units to be bought three months prior to the dividend/bonus and held for nine months after it.

While this hasn't killed off bonus or dividend stripping in entirety, it has certainly made the strategy far more complicated. If you have to hold onto a debt or equity fund for nine months after the bonus or dividend, this exposes you to volatility in the underlying markets. If interest rates spike or equity prices crash after you bet on a fund for a bonus or dividend, your fictional capital 'loss' can sometimes become a real one!

At one time, institutional investors used the dividend options of liquid funds to pay lower taxes on their treasury returns. But this leakage was spotted and plugged too. Not only was a special rate of dividend distribution tax brought in for institutional investors, DDT rates were hiked in successive budgets and stand at over 28 per cent now.

Now, there are two messages for investors to take away from these instances.

Not fair
One, it is clear that whatever ingenious methods investors and tax planners may come up with to lower tax incidence, the usefulness of such methods is likely to be short-lived. For the taxman is just a few steps behind you, trying to devise newer ways to collect his pound of flesh.

Therefore, it is unproductive to spend too much time or effort chasing short-term investment avenues that help you avoid tax.

If you do, and the budget springs a nasty surprise, there is no point in fretting over it.

The tax system is not meant to be fair and equitable to all. It is only meant to maximise revenues for the exchequer. Therefore, while making big investment decisions today (even those such as taking a home loan), it would be best not to take the tax concessions for granted. They may, and can, change anytime in the future.

Focus on goals
Two, while planning your investments, never let tax considerations hijack your primary investment goals. To most Indian investors and a good number of their distributors, financial planning seems to be synonymous with tax planning. Eighty per cent of the time they spend on charting out financial plans is devoted to cutting corners or devising clever ways to avoid tax.

Thus, they buy or discard investment products based on whether they are 'tax-efficient'; no matter if they are badly designed to begin with. Hundreds of investors for instance, buy the low-return high-cost traditional insurance plans just to earn tax breaks on their annual premium. This locks them into 5-6 per cent annual returns for years together, translating into a huge opportunity cost.

Investors go in for the dividend options of equity funds because the dividend is tax-free while growth can suffer short term capital gains. But frequent dividend payouts, if not reinvested, can deprive you of the benefits of compounding.

When saving towards retirement, a foreign trip or a US degree for your child, what you want is good investment returns without undue risks. If it comes with tax efficiency, that's good. But if it doesn't, don't let that put you off from a good investment. It can play havoc with your wealth creation.