VR Logo

The 10 per cent tax hit

This is the first year that meaningful tax harvesting is possible on the long-term capital-gains tax on equity holdings. Is it worth it?

The 10 per cent tax hit

It's the season for worrying about tax gains, especially for those who have long-term capital gains (LTCG) from equities or equity-based mutual funds. Till the 2018 budget, we had all spent close to two decades in the comfortable knowledge that there was no LTCG tax on such investments. However, that long tax holiday ended in 2018, and in a somewhat unexpected way. Instead of the two-tier indexation route that fixed-income and other investments follow, the government opted for a flat 10 per cent tax with a Rs 1 lakh exemption.

To be precise, this tax was to be paid only on gains made since the day of that budget, which was January 31, 2018. Gains made before that were 'grandfathered', so to speak. From February 1, 2018, onwards, selling stocks or equity mutual funds that you have held for the long term (greater than one year, just like earlier) has meant paying taxes on gains accrued since markets' closing on January 31, 2018. If, in any given year, you realise more than Rs 1 lakh of such gains, then 10 per cent of that (plus of course, any surcharges and cesses, etc.) have to be paid as tax.

So essentially, the earlier exemption was still there for gains up to Rs 1 lakh in a year. For a while (a very short while), the Rs 1 lakh annual exemption caused some excitement because it raised the possibility of 'tax harvesting'. This meant that in a given year, if you had any long-term capital gains, then even if you did not actually need to sell any holdings, you should sell enough holdings that would give you a Rs 1 lakh gain. You could then immediately rebuy the same investments. Nothing would change, except that you would have made those gains tax-free for the future. It sounds like free money, and of course it is free money.

However, it's very thin pickings indeed. Essentially, you would save Rs 10,000 a year and gain a certain amount of paperwork to do for your tax returns. You would also have converted some long-term holdings to short-term. This could be a problem if the need comes up to sell those holdings within a year. If all this sounds like a good bargain to save Rs 10,000, then by all means, go ahead and do it. However, for most equity investors, it's unlikely to be a big deal one way or the other.

The reason that this issue has come up this year for the first time is that no one has had much gains since the law came into effect. One year from January 31, 2018, was January 31, 2019, and since then, hardly anyone has had any gains to speak of, if at all till now. Now that some gains have accumulated, the possibility of tax harvesting comes up, thus the discussion in the media and social media.

None of this should detract from the fact that this is a bad structure for a capital-gains tax. The tax exacerbates the worse problem that threatens the Indian saver, who is wallowing in the financially damaging tradition of sticking overwhelmingly to deposits. Savers need all manner of encouragement to switch to equity-based investments. In terms of savings, India is still overwhelmingly a fixed-income country. However, as fixed-income returns have fallen, and savers are still sticking to their habits, more and more retirees are sliding towards old-age poverty. There is no solution to this, except to make equity-based investments simple and attractive to understand and implement. Before the current reimposition of the long-term capital-gains tax, this was very much the case.

The damage from this tax to your long term is actually much more than just 10 percent. It's 10 percent EVERY time you switch investments. Over a long period of investment, there come many occasions when your current investment becomes suboptimal and you need to switch to something else. Earlier, such optimisation of an equity-fund holding was tax-free. Now it has a 10 per cent hit. Over time, this hit can accumulate. How much it accumulates depends on your individual case but because this tax prevents compounding of gains, it could well be 20 to 30 per cent or even more.

This over and above the fact that the inflation hit is there - I'll talk about that in the future. The bottom line is that this is a bad and unfair tax and the government should remove it.