The 10 per cent tax announced on long-term capital gains above ₹1 lakh on listed equity shares and equity mutual funds in the recent budget has caused angst among many investors and contributed to the recent market weakness. But this was a move long coming and justified, at that. There is little logic in why equity instruments should be given princely treatment with tax exemption, when debt instruments such as bank fixed deposits, the mainstay of a chunk of the population, do not get any. Especially given that equity has delivered massive gains to investors over the past few years, even as debt investors are staring at whittled-down returns.
The finance minister pointed out that according to the tax returns filed for assessment year 2017-18, the total amount of exempted capital gains from listed shares and units is about ₹3.67 lakh crore. Surely, such big gains should not be allowed to get away tax-free. The tax on LTCG on equity is expected to give the Government revenue of about ₹20,000 crore in the first year; the revenues in subsequent years may be more.
Specious arguments
The argument that equity carries higher risk and hence deserves tax breaks is specious. So is the argument for tax breaks as an incentive to promote the equity culture in the country. Investors ought to know what they are getting into and align their return expectations accordingly. Investors, as they always have, will slowly but surely adjust to the new-normal, calibrating their post-tax return expectations and investment outlays, despite short-term knee-jerk reactions.
The ‘grandfathering’ provision in the budget exempts long-term capital gains up to January 31, 2018, from tax and softens the tax blow considerably. But equity investors have a point when they complain of a triple whammy in the new tax regime. One, even though tax on LTCG has been re-introduced, the securities transaction tax (STT) still remains. STT was introduced in 2004 in tandem with exempting tax on LTCG on equity. In fairness, with LTCG tax now making a comeback, the STT should go. The Government should not try to have its cake and eat it too. In any case, the collection from STT was quite small, less than ₹10,000 crore a year.
Next, unlike tax on LTCG on other asset classes such as real estate, gold and even debt mutual funds, the tax on LTCG on equity is without allowing the benefit of indexation. Sure, the tax rate on LTCG on equity at 10 per cent is much lower than the 20 per cent tax rate on other asset classes when indexation is allowed. But cost indexation of gains to compute LTCG is a fair principle that results in taxing only real, inflation-adjusted returns. This principle also leaves open the prospect of long-term capital loss in the future, if inflation runs high.
Equity investors should also be allowed the option of cost indexation, even if it means a higher taxation rate. On the other hand, short-term capital gains on equity, held for 12 months or less, continue to be taxed at a sweetheart rate of 15 per cent, much lower than the tax on short-term gains on many other asset classes. There is a case for a hike in this tax rate. All said, despite the tax on LTCG, well-chosen equity investments still remain among the best ways to deliver inflation-beating returns in the long run.
Unfair advantage
The budget has taken the right first step towards correcting the inequity in equity. But in being selective about taxing LTCG on equity while leaving gains from insurance-cum-investment products out of the ambit, the Government has given the latter an unwarranted and unfair tax advantage.
This has increased the risk of mis-selling in the insurance category already notorious for sharp customer acquisition practices, thanks to high agent commissions and regulatory arbitrage. Soon after the budget, unit-linked insurance plans (ULIPs) — market-linked investment products with a dash of life insurance —began to be advertised as superior to equity mutual funds, with comparable high returns, that too tax-free, and insurance to boot.
Now, when both equity and debt mutual funds are subject to tax, why should ULIPs or for that matter any bundled product with a high investment component, be mollycoddled with preferential tax treatment? If the premise for the largesse is to improve the still-abysmal life insurance penetration in the country, exempting ULIPs from tax is not the way to do it. This only helps the cause of those seeking to push what is essentially an investment product over another.
Sure, the cost structure of some ULIPs, especially those sold online, has moderated over the past few years and aided returns. But there are still concerns about long lock-ins, costs such as mortality charges not accounted in declared returns, and lack of transparency about performance disclosures in the product class.
Even now, in many cases, a combination of pure play protection such as term insurance and well-run equity mutual funds (despite the tax) could deliver both better returns and higher risk cover than many ULIPs, all costs factored in.
Tax breaks to incentivise insurance penetration should ideally be restricted to pure play insurance products such as term insurance that offer substantial risk cover at low cost.
Tax breaks for insurance?
There could also be a case, though weak, for continued tax breaks on traditional life insurance products such as endowment, whole-life and money-back policies. These traditional insurance products are again a combination of investment and insurance, but are skewed more towards protection than investment. The investment component in such products is low and debt-based and generates single-digit returns. Also, the protection cover is quite low compared with term insurance.
Even so, such products and their carrot of returns, even if sub-optimal, are perhaps necessary. Particularly for those who stay away from pure play term insurance due to aversion to incurring costs without benefits (on survival) and remain exposed to risk.
ULIPs on the other hand are primarily investment products with a sprinkling of insurance — not quite deserving of the tax exemption they now enjoy. When a ULIP fulfils an insurance need, that is, when the insurance proceeds are paid out to the beneficiary on the death of the insured, the gains can continue to be exempt. But when the ULIP fulfils the investment objective, that is, the payout happens on maturity or redemption, the gains can and should be taxed.
But, wouldn’t taxing ULIPs be cumbersome? How would one split the investment and insurance components? Yes, it could involve complications but such conundrums can be surely handled by our tax mandarins who came up with concepts such as grandfathering for taxation of LTCG on equity. Seeming complexities need not come in the way of levelling the tax playing field among comparable investments.