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Capital tax cleanup

Investors often ignore the impact of capital gains tax till it's too late. A rationalised tax structure will make it easier to correct this.

Capital tax cleanup

One aspect of investments that a lot of new investors have trouble understanding is capital gains and the bewildering variety of ways in which it is applied in India. A recent statement by Tarun Bajaj, the Revenue Secretary, has revealed that the government has acknowledged this as an issue that affects savings and investment behaviour and is preparing to restructure capital gains tax.

The basics of capital gains often come as a surprise to new savers. Used as people are to banks, the idea that the income that deposits generate is taxed as income as it is earned, is pretty natural. When it comes to getting some gains from an investment and then paying tax on it, it comes as a surprise to them that separately from income tax, there is an entirely different kind of tax. It doesn't matter what their income slab is or how their salary is structured, this is a different calculation altogether.

However, understanding of capital gains tax and incorporating it into investment planning is hindered because few investors even know that there is something called capital gains tax. How is that possible? Because of the confusing mess that has been created by governments over the decades.

Investors know that there is a tax to be paid when you sell things but the understanding is that there is a tax on selling stocks which is like this, one on selling debt funds which is like this, another one on property, and so on. Each has its own rates, its own structure of exemptions and its own different definition of what is a long-term investment and what is short-term. On top of that, there is the concept of indexation which is basically inflation adjustment.

Indexation is there because inflation eats away the value of money over a period of time. The entire economy and the value of assets inflate and while calculating gains, this should be compensated for. However, for some reason that the government has not bothered to explain, indexation is not available for long-term equity investments. There is no principle that supports this but it is what it is.

Anyhow, it's great news that some kind of a fixing of the capital gains tax structure is on the way. I hope it's thorough rather than just tinkering. There are four parts to the structure: asset class, the periods for long and short term, the rates for each, and indexation for long-term. There are also some additional qualifiers, like the Rs 1 lakh per year exemption for equity. Hopefully, all this will be put into a coherent framework that will help savers understand and add a capital gains perspective to their investments which is missing for many right now.

For example, people will say that a 1+ year bank deposit and an investment in a debt fund both return about 5 per cent, so they are essentially the same. Well, not even close. In the deposit, tax is extracted from you every quarter and that much money is then not available for compounding further, whereas in the debt fund, all the money keeps compounding till you redeem it. Even keeping aside the rate of tax, this difference alone is appreciated by too few investors. Another common example, an equity (or equity fund) investor who churns investments is going to have post-tax returns much inferior to one who tends to buy and hold for long periods even if the pre-tax returns are the same.

Each investment decision must be made with a background awareness of how it will play out in terms of capital gains tax when you finally redeem it. Experienced investors all do it, but beginners should make an effort to learn. If the government actually rationalises the structure, then that will just make it all much easier.