A lot of my equity-fund investments are in dividend and dividend reinvestment options and not growth options. Will the new tax on dividends affect me?
Yes, it will. Though you do not have to pay tax on dividends received from your equity funds, the fund will deduct the distribution tax of 10.4 per cent every time it declares a dividend. This tax will come out of the dividend option NAV and will thus impact your long-term returns. In the case of the dividend reinvestment option, the tax will be deducted before reinvestment of the dividends declared. Therefore, if you had invested in the dividend-reinvestment option of an equity fund mainly for tax planning purposes, you would be better off switching to the growth option of the same fund now.
If you invested in a dividend plan in order to derive a regular 'income' from an equity fund, that was a bad idea to start with. Given the high degree of volatility in equity-market returns, equity funds were never a great vehicle for steady income. Therefore, it makes sense to switch to the growth option.
But remember that switches are treated as redemptions for tax purposes and will attract STCG or LTCG tax. Therefore, if you've been holding the fund for over a year, it is best that you opt for the switch before April 1.
The Finance Bill does not allow inflation-indexation benefits on the new LTCG tax on equity funds. But indexation is allowed on debt mutual funds. So, with inflation taken care of, has this made debt funds more attractive than equity funds over the long term?
Yes, the lack of indexation benefits on equity funds is a bit unfair. You are right that allowing inflation to be indexed substantially lowers the tax burden for debt-fund investors. The proposal to levy LTCG tax at 10.4 per cent on equity funds without indexation will definitely narrow the return gap between equity and debt funds, for long-term investors.
But one can still expect equity funds to deliver a higher post-tax returns over the long-term because the markets do have to compensate equity investors for the higher risk taken over risk-free avenues. But with the gap between equity and debt returns narrowing, investors will have to decide on what is an acceptable level of reward for the volatility they take on with an equity fund.
To test this out, we did a simple hypothetical illustration of two investors who parked Rs 20 lakh each in a diversified equity fund and an income fund this year and held on for the next 10 years. We assumed a 12 per cent CAGR on the equity fund and an 8 per cent CAGR on the debt fund for the next 10 years, with inflation assumed at 6 per cent per annum. At the end of 10 years, we found that the equity-fund investor would receive a post-tax return of 11.18 per cent with flat LTCG, while the debt-fund investor would receive a lower 7.61 per cent after LTCG with indexation. That's a 3.57 percentage points extra reward on equity funds.
But this is a hypothetical case that assumes both equity and debt returns. The actual risk premium that equity-fund investors manage to earn over the next five or 10 years will depend a lot on how those assumptions pan out in reality.
For instance, if equity funds manage only 10 per cent instead of 12 per cent, we found that the extra 'risk premium' on equity funds would fall to 1.67 per cent. For some investors, that premium may not appear sufficient compensation for the volatility of equities. If debt-fund returns turn out lower, at 7 per cent, equity funds can deliver 4.50 percentage points extra, which appears a sizeable reward for risk-taking. Again, if inflation turns out higher at 7 per cent, post-tax returns on debt funds get a nice boost and the gap is narrowed to 3.38 percentage points.
There can be many other scenarios as well. But to cut the long story short, the lack of inflation indexation for the LTCG tax on equities makes it imperative that only investors with an appetite for risk choose equities over debt. Jumping from fixed income to equities just for tax reasons can lead to regret.