Tax exemptions or any beneficial tax treatment, in the context of investments, are not only about the exemptions but also carry a message from the government. The message is about what the government wants to prioritise. It could be a national priority (for instance, infrastructure development and allowing tax breaks for related investments) or it could be certain savings habits which it incentivises (for instance, Public Provident Fund for retiral savings).
In the context of mutual fund investments, the eligibility period for debt funds’ long-term capital gains (LTCG), which is subject to lower tax rate than that on short-term capital gains (STCG), was increased from one year to three years in the 2014 Union Budget. However, for equity or equity-oriented mutual funds, the eligibility period for LTCG tax is one year. Till recently, LTCG from equity funds was tax-free; now a tax of 10% has been imposed. Going by the inherent nature of the two asset classes, equity is more volatile and hence requires a longer holding period. Debt is relatively less volatile. Though a long horizon is desirable, for investments with a short horizon, debt is preferred. However, going by the “messaging” of the tax rules, you are incentivized to hold debt for 3 years, to avail a lower tax rate. In equity funds, the implication is, you are required to hold it for one year, though the differential (15% versus 10%) is not much.
There is a skew here, though the investor can hold both equity and debt funds for a much longer period than one year or three years. The authorities need to guide the investors properly as not all investors are savvy to understand what is good for them i.e. the benefits of long-term holding. Another anomaly is, the LTCG period for a listed bond is one year, but for the same bond, if held through a mutual fund, the holding period goes up to three years. Given the wholesale nature of the bond market, mutual funds are supposed to be the vehicle for the masses and need to be incentivized, not direct bonds accessible to corporates and HNIs.
Moving to insurance, insurance premiums get tax exemption under Section 80C while the investment is being made; any interim payments and maturity payments are tax-exempt under Section 10(10D), as long as premiums in a year are less than 10% of the sum assured. In tax parlance, this is known as EEE i.e. exempt-exempt-exempt: exemption while making the investment, on interim money flows and on maturity. While insurance needs to be incentivized through tax breaks, unit-linked insurance plans (Ulips) are essentially investment plans with an insurance cover thrown in. The pure insurance coverage that needs to be incentivized for the benefit of the population is term insurance, which does not have any investment element. The skew here is that there is a tax ‘arbitrage’ i.e. when one invests through the insurance route as against the mutual fund route, there is a tax advantage.
What’s wrong with that, you may ask, if the investor gets an insurance coverage as well. The issue is, expenses are higher in insurance products than mutual funds, which the investor may not be aware of. In the realm of mutual funds, tax breaks are available in equity- linked savings schemes (ELSS), which are equity funds with a 3-year lock-in. On maturity, ELSS funds are subject to LTCG tax. In tax parlance, ELSS funds are ETT i.e. exempt while making the investment, taxable on interim flows and taxable on maturity. The “messaging” given by the government, to channelize investments through insurance over mutual funds, needs to be debated. It may be noted that the holding period required in insurance is longer because the limit of 10% of the sum assured implies a suitably long premium paying period.
Now let’s look at the tax scenario on real estate, which is a slow moving asset class because transactions and valuations do not happen at the speed of financial assets like equity or debt. The eligibility period for LTCG is two years. People may not buy or sell a house every two years, but the tax rules are lenient on you if you hold it for just two years.
Net-net, the holding period from the perspective of taxation needs to be aligned with the nature of the asset class i.e. how volatile are market movements, how long should the investor ideally hold it and what should the government incentivize, keeping in mind national interest, benefit of the people and awareness level.
There is a logic from the government’s perspective as well. Closed-end debt mutual fund products like fixed maturity plans (FMPs) are somewhat similar to fixed deposits, but FDs are taxable as interest at the marginal (slab) tax rate. Mutual funds are meant for the masses and corporate treasuries may take advantage of the tax “arbitrage” in FMPs over bank deposits. However, in open-ended funds, the investor is undertaking market risk and the skew discussed here needs to be debated.
Joydeep Sen is founder, wiseinvestor.in