As stock markets fly to new highs, the new term is becoming an increasing focus – tax collection. This is especially true for equity mutual fund investors.
For the uninitiated, this refers to the attempts of mutual fund investors to obtain an exemption from long-term gains (up to ₹ 1 lakh) each financial year on their investments. This is achieved by selling their long-term capital investments until their total return is a total of ₹ 1 lakh (per year), and thereafter by repurchasing the investment at the same price (or NAV). Since the sale price now becomes your acquisition cost, you can repeat this series of sale and repurchase transactions after one year (when these capital investments qualify for long-term capital gains). Performing this year after year reduces your total tax liability to the extent that you finally sell your equity fund investments.
But the game is not worth the candle, given that the savings each year are limited to just 10,000 JPY (long-term capital gain of 10% per 1 lakh). In addition, this seemingly good idea has many practical obstacles. Let’s talk about some of them.
Before discussing the technical obstacles they face, the rules of taxation must be clearly understood. The exemption of up to ₹ 1 lakh for long-term capital gains (LTCG) applies only to the aggregate LTCG for equity units – listed shares and / or equity-oriented mutual funds – in a financial year. Gains will be taxed in the long term only if such investments are held for more than 12 months. In addition, the Income Tax Act defines equity-oriented mutual funds as only those where at least 65 percent of the fund’s income is invested in equity shares of listed domestic companies. In the case of a fund of funds (FoF), the underlying fund should invest at least 90 percent of the total income in listed domestic companies in order to classify the FoF as capital-oriented funds.
This clearly excludes funds that invest predominantly in international stocks, debt securities and unlisted Indian stocks, etc. For which taxation rules differ.
In addition, if you have made your investment through systematic investment plans (SIPs), then the acquisition costs will be based on the units originally purchased – the first-first-first method. Also, keep in mind that it took 12 months from the date of purchase of each SIP installment for capital gains to be taxed in the long run. Otherwise, you will eventually have to pay tax at the rate of 15 percent on short-term capital gains.
Penial and pound stupid
Tax collection differs from ordinary profit provision in that the investor still remains invested in the fund. In order to remain invested, you would have to repurchase your own mutual funds, preferably in the same NAV, to avoid losses due to the difference in daily NAVs. To this end, investors must take into account many factors.
First, the investor should take into account the time intervals for transactions. The time limit for stock schemes is set at 3pm – certain websites (/ applications) and brokers may have time before foreseen by the house funds. That is, depending on the availability of funds, if both transactions are executed within the time limit, the NAV will apply for sale and repurchase on the same day. Any delay in the transfer of funds (to the AMC account) or any other technical failure can expose investors to volatility in the stock markets – this is the difference in NAV in the sale and repurchase. Your purchase transaction may also be delayed due to the time lag between debiting your bank account and credit to your AMC account – generally too large in the case of transactions executed using NACH mandates, NEFT and RTGS. The result of changing the NAV can disrupt your investments made for long-term goals.
Second, since sales revenue is not immediately credited to your account, you should maintain a fat balance in your bank account so that you can purchase units in the same NAV. Although SEBI provides a maximum of 10 days to post sales revenue to your accounts, fund houses typically need up to three days. However, the funds for the repurchase transaction must be allocated to the house of funds, before 3 pm on the same day, in order to use the same NAV.
Third, we note that several funds have stopped accepting lump sum purchases. For example, in September 2020, after an overvaluation in the small capitalization area, SBI’s small capitalization fund closed for lump sum investments after September 7, 2020. Furthermore, in its SIP investments, the fund has an upper limit of ₹ 5,000 per month (per investor).
Four, keep in mind other incidental costs such as brokerage fees (applicable in the case of foreign exchange funds) for multiple transactions.
Five, the concept of tax collection presupposes a market situation in which profits from long-term equity funds are evenly distributed over the years. But stock markets don’t always show linear growth. For example, while Sensex rose 11 percent and 17 percent, respectively, in FY18 and FY19, respectively, it fell 23 percent in FY20. After that in FY21 (so far) the index rose by 71 percent. This instability can eventually disrupt your tax collection plans.
Net-net, the process is too tedious for a maximum saving of 10,000 JPY at the end of each financial year. Investors need to see if these marginal savings are worth the pain.