Arun Jaitley has introduced 10% tax on long term capital gains (LTCG) on equities (including mutual funds). This has upset many investors and many hardcore BJP supporters are also questioning this decision. Market was already waiting for some trigger for correction and union budget obliged. Market tanked by 800 points on Friday and small & mid cap index corrected by more than 4%. Small & Mid Cap were already facing selling pressure throughout January and this has come as an additional blow. Since equities are highly traded securities, the implication of 10% tax will be more than what it looks at face value. In this article, we will explain this new tax, impact to investors and our advice on it.
What is this new grandfathered taxation?
LTCG on equity will be grandfathered and taxed at 10% on accumulated gains made after 31 Jan 2018 provided gains are more than one lakh rupees. The usage of word grandfathered has created a lot of confusion. In simple terms, grandfathering means giving exemption to all older cases. This is used if you have to introduce a new law but do not want people to get impacted who have already made transactions under old laws. So all new transaction will be governed by the new law while older transactions will be grandfathered or given exemptions. Before we move on to how profit will be grandfathered, it is important to understand the applicability of this law.
- Who will enjoy grandfathered tax advantage? All equities bought previously i.e until 31 Jan 2018. Anything you buy now will be subjected to 10% taxation on actual buy & sell price. So forget grandfathered taxation for all new purchases. It will only benefit your past holdings
- When is this new rule LTCG @ 10% Applicable? Any equity transaction from 1 Apr 2018 onwards where gains are more than one lakh. Remember budget is for next fiscal year, so if you sell within 31 Mar 2018, this rules does not apply.
Now you are clear of this new tax rule’s applicability & the scope of grandfathered taxation. Let’s see how taxation will be done for cases where grandfathering is applicable.
& Bears have got a reason to roar
Immediately, after taxation news broke out, investors are rushing to book profit and avoid 10% taxation. Liquidity which was driving this rally has suddenly stopped and now people are pulling our their money as knee jerk reaction. Mid & Small caps were driven largely by domestic liquidity and they have to bear the maximum brunt of it. Truly, bears have got a solid grip on dalal street.
But wait, is there a reason to sell?
Selling stocks with this news is purely an emotional decision and not rational one. People are selling their stocks like pancakes. Even short term investors and traders are also selling who have no impact from long term taxation changes. Ask yourself what has changed, has your investment thesis changed? Or your company has gone bankrupt because of this rule? Many will say that they want to save taxation and hence booking profit. But your profit is already saved (i.e grandfathered until 31 Jan 18), see above table to understand grandfathering. Even if you sell now or 10 years later all the profit you made until 31 Jan will remain exempted under grandfathered taxation rule, so what is the hurry? On top of that, whatever you invest now onwards will anyways be taxed under new rule. So technically there is nothing for you to save or avoid. Rule has already been established. We have to accept it as the law of land and move forward.
If you are thinking to bypass this rule by booking profit as soon as it approaches one lakh, that will also not work since over full year, your accumulated profit will be more than one lakh. So only if you are going to book less than one lakh profit in the whole year, you will be spared from this rule.
Coming back to panic selling, you may have a genuine reason to sell only under these three conditions:
- Your goals is nearing completion (within 2 years) and you want to book profit to safekeep the money.
- Your original investment theory has gone wrong. Certain assumptions are not working and you want to exit that stock.
- You are planning to reduce equity allocation and move to other asset classes.
Is equity less attractive with 10% taxation?
We don’t think so! 10% is the least tax you will have to pay anywhere else. Infact it will be usually higher than 10% in other asset classes because it will be taxed as per your tax slab. If average return from Indian equities is considered at 14% then it will still give you 12.6% post tax returns, which is way higher than other asset classes.
It is a kind of iceberg tax!
While equity is set to be taxed at 10%, in reality people will be paying more than 10% on it. This is due to our investment behavior. Consider a person who is booking profit today in order to avoid tax. What will he do next? Since debt is still giving 5-6% yield and real estate is down, he will again invest in equities subjected to 10% taxation. Now 10% of profit is siphoned every time he does profit booking. And this cycle gets repeated. Over a period of time, profit from same amount will be subjected to 10% taxation multiple times. So it is better to have a long term approach and not to give 10% tax every time alongwith STT (securities transaction tax) and brokerage fee.
The biggest beneficiary of this mania will be the brokerage houses as the number of transactions have swelled up which will lead to hefty brokerage commissions. No wonder they will advise you to book profit before 31 March to save tax but can we save something which is which is already exempted (grandfathered)?
As reader of AI post, we want you to make smart decisions and not to follow herd mentality. Indian economy is picking up and earning recovery can be seen in Q3 results. Such a wild correction gives perfect opportunity for ace investors to invest more. Recent correction has brought down many promising stocks into buying range and we will be recommending them in our February report. Subscribe with us to benefit from sensible investing and stress free wealth creation.
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