Can government remove 0% tax on long term gains of stock funds ?

Yes, They can !

Recent budget changed the taxation of long term capital gains of debt funds. Investors in debt funds were enjoying 20% with indexation benefit on their investments in debt funds.This tax law has resulted in capital losses some time and was used to adjust gains from other capital assets.

In other words, the investors were enjoying fixed deposit gains and used indexation loop hole to claim losses. (Please read my earlier article on this tax loop hole: Fixed Income Investing – Have the cake and eat it too ! )

This budget amendment has shocked several mutual fund investors and one of them, also my friend wrote me an email :

Based on the recent ‘retroactive’ law passed, would you recommend selling and repurchasing all equity funds (units that are more than 1 year old )? This way any future law that kicks in, the tax liability will be restricted.

This made me dig up history little bit to read about changes that happened in the personal taxation laws in India.

In 1970-71, the personal income tax had 11 tax brackets with the tax rates progressively rising from 10 per cent to 85 per cent. When the surcharge of 10 per cent was taken into account, the maximum marginal rate for individuals was a mind boggling 93.50 per cent.  In 1973-74 the highest tax rate applicable to an individual could have gone up to an astronomical level of 97.50 per cent!

I provided those links in the bottom of this article.

Section 10(38) exempts capital gains completely from taxation arising out of sale of stocks and stock mutual funds. A Stock mutual fund is one which has about 65% stocks listed in India. [ A mutual fund holding majority of foreign stocks is not considered as exempt. ]

This section 10(38) is introduced in 2004. [ref: 1st October, 2004 vide SO 1058(E), dated 28-9-2004.; source: Income tax website]. So, the 0% tax rate investors are enjoying now on the long term capital gains has been in existence just for a decade only. There is no guarantee that this will not be changed. We have enough indication and experience from our finance ministers who wanted to play to the gallery and change tax laws without any notice. They can simply say the reason is rich people are exploiting the tax system in India while the poor are paying taxes.

What is shocking is government changes these laws without enough notice for investors to make any adjustments to their portfolios. This is nothing but Tax Terrorism.

Financial planners look for strategies to protect investors from market events and carefully design investments. But if government of India can show some lame reason and change the laws at will, suddenly without enough notice, all are portfolio plans are at risk. Isn’t it ?

Changing tax laws are fine, it has been done by all countries. But no one does it like our government without giving enough notice. So, I see merit in my friend’s question about the risk of future taxation. We train our investors to cover the market risk by diversification, but what about unseen tax risk ? How do we cover ourselves from those shocks ?

When this tax exemption rule was introduced in 2004, the Sensex was around 5000+ and now we are at 25,000+. Those who started investing after this 0% tax law change, would be sitting on 5X profits. 400% return in 10 years time. And ZERO tax paid ! Some of the actively managed funds in India delivered even higher return !

A government that continuously tinkering with tax regulations is a major risk to such big profits made in the market.

Interestingly my friend while asking the tax risk question also gives a way out for this dilemma. How does the solution work ?

By doing this selling and buying back, you are rising your funds cost basis. Future capital gains are computed from this new purchase point. All the gains made so far are yours to keep without paying any taxes.

For example, if you have invested 1 Lakh and if it has grown to 5 Lakhs, you are sitting on 4 Lakhs capital gains. Even a 10% tax on this amount will set you back by Rs.40,000. By selling and buying back the funds again for 5 Lakhs, you have increased the cost basis to Rs.5 Lakhs. So, only gains over this amount will be subjected to capital gain taxation.

In a recent article in valueresearchonline, Mr.Dhirendra Kumar advocated the same defense strategy. He wrote :

Could there be a tax googly in equity funds too?
Are your existing equity fund returns safe from changes in tax laws?
Not really

If you have longstanding equity or equity fund investments that you intend to keep for the long-term, then it might makes sense to just sell these investments and buy them again. That sounds like a strange idea, but if you draw a lesson from what the government has done in this budget, then this roundtrip of your investments could be one way of ensuring the returns that you have already generated stay safe from taxation.

Things to watch before pulling the trigger:

  1. Almost all equity funds have exit load. (usually it is about 1 year and some have longer period). Don’t sell within the locking period.
  2. Mind you have to pay 0.1% STT on the sale proceeds. For Rs.1,00,000 sale, you will have to pay Rs.100 in STT.
  3. Sell only if you have very high profit and invested over very long time horizon.
  4. Staying out of the market in current situation pose another risk. You could be out of market and the market can move quickly ahead. And you will end up buying the same units at higher price. Hence put your blocks on sale in stages. And buy them back as quickly as money is credited in the bank account.
  5. Sell and buy the same equity funds back, if you are happy about them. Or use this opportunity to move to other better performing funds.
  6. Same strategy can be applied for individual stock investments also.

Disclaimer :  We at iAspire always recommend buy and hold strategy and ask our clients to hold the mutual funds for very long time. Even if some funds have short term poor performance, we ask our clients to give some time for the fund manager strategy to work. We dislike indiscriminate selling and buying of funds. But as financial planners we have to protect the clients’ interest first. It is only prudent action from the clients interest to raise the cost basis in defense of the any sudden introduction of taxation laws for stock funds. Please talk to your financial adviser to check suitability for your situation before using this strategy.

Further reading :
(a) 50-year trend of Indian personal tax rates
(b) Income Exempt from Taxes
(c) Could there be a tax googly in equity funds too? 
(d) Change in debt fund taxation is too broad a stroke

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