PremiumWho doesn’t want to save on taxes? With each budget, the financial system innovates with new products that reduce the tax liability of investors
Who doesn’t want to save on taxes? With each budget, the financial system innovates with new products that reduce the tax liability of investors. Mint examines some of the products and investor strategies in the mutual fund (MF) spaces that created a tax-efficient design, until the loophole that allowed them to flourish was plugged.
From 2004 to 2018, there was no tax on long-term capital gains (LTCG) on equity. This also applied to equity MFs held for over 12 months. In case of dividends, a dividend distribution tax, or DDT, was levied. However, dividends paid net of this tax were tax-free in the hands of investors. This allowed investors in top tax brackets to reduce their tax outgo since DDT was lower than the highest rate of marginal tax.
Mutual Fund Bonuses
Some debt MFs declared ‘bonus’ units at periodic intervals. Some investors took advantage of these declarations to conduct ‘bonus stripping.’ Bonus stripping is an act of buying the units of a fund with an intent to earn bonus units and thereafter sell original units at reduced prices. This is to use the loss incurred on sale of original units to set-off against other capital gains.
Say, for instance, an investor named ‘X’ bought 500 units at ₹100 each just before the record date of the bonus issue of 1:1. Post the bonus issue, X holds 1,000 units and the price of these units would become ₹50 each; after the bonus issue, the unit price of the fund falls in the same proportion of bonus units issued.
In case of bonus stripping, X would sell the original 500 units at ₹50 each after the bonus issue and decides to use the loss of ₹25,000 [500*( ₹100 – ₹50)] to set off against other capital gains. The remaining units acquired on bonus can be sold just after a year and benefit from LTCG exemption available. This scenario was applicable for the period before 2018. Even after 2018, when LTCG tax exemption on equity was removed, it was still beneficial as the gains were taxed at a concessional rate of 10% on gains in excess of ₹1 lakh. However, a few years ago, the government introduced a provision that disallowed such set-off of loss incurred through bonus stripping.
Dividends
Dividend stripping is a concept that is similar to bonus stripping, where the users intend to benefit from capital loss arising on sale of shares or units at lower price, post-dividend.
This concept was popular when dividend was exempt in the hands of shareholders. But not anymore, as such income is taxable at individual’s applicable slab rate and makes tax planning less effective.
When dividends were tax exempt in the hands of shareholders (from 2003 to 2016), the dividend plan from MFs was a preferred option for those looking for periodic income. In some cases such MFs were missold to investors as avenues for getting regular income through dividends. But in budget 2016, a 10% tax on dividend income exceeding ₹10 lakh per annum was introduced. Budget 2020 made the entire dividend income taxable.
Now, the systematic withdrawal option (SWP) that also offers regular income to MF investors fares better than using dividends for regular income. This is because each withdrawal is subject to capital gains tax treatment that is beneficial compared to tax on dividend, especially for those in the higher tax bracket.
LTCG
The exemption of tax on LTCG in budget 2004 made investors look at equity as an asset class favourably. It became more attractive when there was a change in the tax rule of debt funds in budget 2014. This budget increased the qualifying period for LTCG in debt MFs from 1 year to 3 years. The same period for equity MFs remained 1 year. MF houses innovated by launching categories like arbitrage funds which were equity funds for tax purposes but functioned like debt funds in practical terms through the usage of hedging vehicles like futures and options.
Hence, investing in arbitrage funds for a short term (1-3 years) is more tax efficient than investing in debt fund. Categories like equity savings funds and balanced advantage funds make more limited use of the tax efficiency of equity, while functioning as debt funds.
Outside the mutual funds space, market-linked debentures (MLDs)— structured products that invest in both fixed-income and derivative instruments—also gained traction among high net worth individuals. Listed MLDs are taxed at 10% after a 1 yr holding period, similar to equity. But many MLDs are akin to regular bonds with only a nominalequitylinkage.
Not all new offerings prompted by a change in tax rules are inefficient. However, investing for tax benefits alone is not advisable. It is important to check the suitability of the investment product to one’s own risk profile and how it fits in the overall portfolio.