Getting Down to Brass Tacks
Earlier in the year, the ﬁnance minister Mr Arun Jaitley, while presenting the Union Budget announced the introduction of a long term capital gains tax (LTCG) on gains from equity investments along with the introduction of a dividend distribution tax (DDT). The immediate reaction of the investment community was one of panic. However, on further reading, it is evident that the introduction of these taxes is unlikely to have a material impact on the returns from equity investments.
In general, taxation is viewed through a lens of disdain. Which is why, often, when rules and regulations pertaining to taxation are announced, most people adopt a defensive tone. However, like most things in life, it is always beneﬁcial to read the ﬁne print.
Basics of long term capital gains tax
- Equity investments that earn a return exceeding 1 lakh will attract a long-term capital gains tax of 10%.
- This is applicable only from March 31, It is important to note that gains accrued till January 31st, 2018 will be grandfathered, which basically means that gains made up until that point will be exempt from LTCG.
- The budget proposes to tax these capital gains only from this point This means that for the purpose of calculating capital gains on existing holdings, cost of acquisition for equity investments will be equal to the value of the investment as on 31st January 2018 or the original cost, whichever is higher.
An example is always betterSteps to calculate long term capital gains tax
- Compute the value of your investment as of 1st April 2018
- To compute the cost of acquisition, compare the original cost of the investment with the value of the investment as of 31st January 2018
- For the purpose of calculating LTCG, the higher of the two will be considered as the cost of acquisition
- Compute gains from equity Investments as Value as of 1st April 2018 less cost of acquisition
- Subtract an amount of 1 lakh from the gains computed in the above step
- If the result is a positive ﬁgure, Then apply LTCG tax of 10% on this
LTGC – Impact on returns
Let us evaluate the impact of LTCG on an equity investment. Assume that an investor invested Rs 100000 in an equity investment. The value of this investment increases at a CAGR of 12%.
The table below showcases the growth in absolute value of this investment over the years and the subsequent impact of LTCG on gains realised.
- In most cases, the impact of long term capital gains (LTGC) tax on equity returns is marginal
- For the first 5 years gains from the investment do not exceed INR 1 lac. Consequently, redemption in year 5 does not attract any LTGC tax
- As the holding period increase from 15 years to longer duration, the impact becomes minimal
Impact of tax on long-term returns
- The difference between 7 years returns and 1 year return is 0.15%
- The difference between 25 year returns and 1 year return is: 0.41%
The introduction of long term capital gains tax will have little to no impact on equity returns from long-term holdings. To be able to truly capitalize upon the opportunities that equity investments present, one must stay invested for the long-term and let the investment grow. As we have demonstrated above, as the holding period of investments increases, the impact of long term capital gains tax becomes minimal. Historically, equity investments have performed well over the long-term. Thus, withdrawing cash in the form of dividends might not necessarily be the best option. Hence, for investors in equity mutual funds who are looking to capitalize on the long-term value of equity investments, the introduction of these taxes will have little or no impact.