Since the Union Budget was presented on February 1, 2018, there have been lots of reactions initially, and then discussions on how to optimise the impact of long-term capital gains tax (LTCG) like SWP / booking profits up to LTCG of Rs 1 lakh per financial year. Now let us look at the worst case: you have crossed the threshold of `1 lakh and now you have to pay LTCG tax. What is the impact on returns?
We will discuss that now, but it is nothing to deter you from investing in equities.
The proper way to look at returns is compounded annualised growth rate (CAGR). The longer the time period, on a CAGR basis, the impact of tax on your returns comes down, due to the compounding effect. Let us look at a few examples.
Let’s say you invest Rs 100 in equity now, i.e., after February 1, 2018, to not complicate things with the grandfathering clause. After two years, your Rs 100 grows to Rs 121. This implies a CAGR of 10% pre-tax. The tax rate is 10% plus 4% cess, i.e., 10.4%.
We are taking the tax rate at 10.4%, which is the worst case scenario, after exhausting the limit of Rs 1 lakh. On the gain of Rs 121 – Rs 100 = Rs 21, at 10.4%, the LTCG tax incidence is `2.18. On the net-of-tax return of `18.82, the CAGR return is 9%. Hence the impact of the tax of 10.4% on return is 1% in CAGR terms.
The point here is, equity is meant for long term and not just two years. Now let’s say Rs 100 grows to Rs 161.05 over five years. The CAGR returns, pre-tax, is 10%, same as the previous example. Tax incidence at 10.4% is `6.35. On the return of `54.7, the CAGR rate is 9.12%. Hence the impact on return is 10% – 9.12% = 0.88%, lower than 1% over a holding period of two years.
From five years, let’s move on to 10 years. `100 grows to `259.37. The pre-tax CAGR is 10%. Net of tax at 10.4%, return is Rs 142.8. Net CAGR return is 9.28%, i.e,. impact of tax on return is 10% – 9.28% = 0.72%. Progressively, over a longer holding period, the impact comes down from 1% to 0.88% to 0.72%, since the tax is payable only when you sell the shares and book profits whereas your money compounds over the years without any tax incidence.
On the salary we receive, at the highest bracket, we have to pay tax at 30% plus surcharge and cess. On goods and services, depending on the item, GST ranges from nil to 28%. The one objection that remains on equity LTCG is that there is no indexation benefit. Indexation is available on debt mutual funds over a holding period of three years and real estate over a holding period of two years.
The tax rate also is higher at 20.8%. Given the holding period and tax rate, 10.4% over one year is not that unfair. And who knows, sometime in future the government may increase the tax rate on equities, increase the holding period and give the benefit of indexation.
Every investment is subject to tax. Equity long term was exempt, which has been brought into the tax net now. The only ‘anomaly’ that remains, i.e investment without taxation, is unit-linked insurance plans (ULIPs). It is not advisable to go for any investment based on taxation only; it should be based on merits. Every investment has its own fundamental pros and cons and suitability aspects. If you are convinced that ULIPs are fundamentally better / suitable for you, then go for it. Otherwise, giving up less than 1% of your return should not be a deterrent for equities.