Profiting from taxation through equity markets
India has a robust demographic advantage and an extremely competitive industry with world-class leaders. Our diversified industry spanning all sectors of the economy backed with Government policy support ensures that the current decade will belong to India.
Bhushan Mahajan, Chairman and Managing Director, Arthbodh Shares and Investments Private Ltd explains how to use taxation for your advantage to generate efficient post-tax returns.
Let us first complement our government to offer an extremely tax-friendly regime while computing taxes on capital gains arising out of the sale of equity shares, short term or long term.
Barring tax havens like the Cayman Islands and some others, developed countries like the USA, Japan, Finland, France etc. have tax rates on or above 20 per cent. In many cases the gains get added to your income and an individual’s personal income tax rate is applicable. In Canada 50 per cent of gains are exempt and the rest are added to the income and taxed. However, in addition to the concessional tax rate; many other provisions make equity investment attractive in our country.
In our country, the equity culture is evolving. There are around 2 to 3 crore Individuals who are exposed to the equity market, directly or through mutual funds in a population of above 130 crore Indians. The majority of our population is conservative and believes in fixed income. Being a developing country, with decent inflation, banks used to offer ‘optically’ good returns on fixed deposits, by far the most popular product. The current bull run and the pandemic has forced our millennials and those working from home to look at equity seriously.
India has a robust demographic advantage and an extremely competitive industry with world-class leaders. Our diversified industry spanning all sectors of the economy backed with Government policy support ensures that the current decade will belong to India. If the nominal GDP growth is around 11 per cent to 14 per cent in this decade, the returns from stock markets aka equity are likely to be equal to or more than this figure. On one hand, we have unattractive bank interest rates which are fully taxable and on the other hand, we know that equity returns will not only beat these returns but also beat inflation, we have to deploy capital to this asset class to create wealth and to create comfortable retirement income. The icing on the cake is the concessional rate of tax. Let us see how we can use the taxation to our advantage to generate very efficient post-tax returns.
Before we go ahead with our narrative, let me have a few caveats.
- Taxation considered here is for Resident Indian. And Hindu Undivided family entity (HUF).
- It is also assumed that the reader is well versed with investing in the share market directly. Thus, the reader knows that investing in shares of a well-managed company with good growth in sales, profits, margins and market share will result in long term appreciation. This article is not about how to choose stocks.
- For newcomers the best way to take advantage of taxation while investing in equity is through investment in well-diversified mutual funds, this will be covered in the later part of the article.
In 2018, late Arun Jetley, the then finance minister; reintroduced the long-term capital gains tax of 10 per cent on profit from shares, if held above one year. Even though he gave a relief through grandfathering provision, the rally in the stock market for the last two years has ensured that everyone who profits, pays this tax.
Windfall gains through Grandfathering
The finance minister announced that gains up to January 31, 2018, would be grandfathered. This meant that the extent of such gains up to that date would not be taxed. An example of how this would work was also given by the finance minister in his budget speech. If a taxpayer had acquired the shares before January 31, 2018, he/she could substitute the fair market value (FMV) of the shares as of January 31, 2018, for his/her actual cost, while computing the gains.
As an illustration, if an equity share is purchased six months before January 31, 2018, at Rs 100 and the highest price quoted on January 31, 2018, in respect of this share is Rs 120, there will be no tax on the gain of Rs 20 if this share is sold after one year from the date of purchase. However, any gain above Rs 20 earned after January 31, 2018, will be taxed at 10 per cent, if this share is sold after July 31, 2018.
The above provision has given total relief from taxation for an investor holding shares for the past 5-10-20 years or more for appreciation till January 31, 2018. In addition to the investor, it also gives relief to the promoters of corporates, where holdings are large and appreciation in share value since the inception of the company can be exponential. In the current year’s budget, the finance minister has given further relief by reducing the surcharge on capital gains above two crores from 37 per cent to 15 per cent.
Taxation of STCG and LTCG from shares
Currently, if an investor books profit in shares during one year (the holding period can be as little as one day) the gains are termed as short term and taxed at 15 per cent plus surcharge. Profit in shares held above one year is taxed at 10 per cent plus surcharge. This is if the long-term profit exceeds Rs one lakh. In other words, between husband and wife, you may book tax-free income of up to Rs 2 lakh every year. This is easily possible with shares or mutual fund holding of 20 lakh and above. It, therefore, makes sense to book small periodic profits every year in your share and mutual fund holdings. You may consume the profits or reinvest in a similar or different asset class like debt.
This is a great relief for all those in tax brackets of 20 per cent and above. Further, bonus stripping ( buying a share cum bonus and selling it post bonus at a notional loss ) was allowed in shares to compensate against short term profits till this financial year. This loophole has been plugged in budget 2022.
The above relief is available as long as the transaction takes place on the stock exchange, where an STT (security transaction tax) of 0.1 per cent is paid at the time of the transaction. STT was introduced in 2004, thus it exempts all stock market purchases prior to that. Post-2004, it is mandatory to pay STT at least on one side of the transaction, either sale or purchase. This gives relief to shares purchased through ESOPs and sold through buybacks.
Most of the well-managed software companies have no debt and have good cash on their balance sheets. This is used to offer buyback of shares from shareholders. A case in point is the current buyback proposed by TCS. As against a market price of Rs 3700-3800, the company is buying back its shares at Rs 4500. This gives a decent profit to the retail shareholder at a concessional tax rate. Holding of 40 shares at Rs 3750 sold at Rs 4500 gives a profit of Rs 30000 and tax of 4500 outside transaction costs. This works out to up to 17 per cent of profits in just one month. Such opportunities are regularly available in the stock market.
Role of mutual funds
All the equity taxation laws apply to equity mutual funds where the investment in equity shares is above 65 per cent. Thus, one can use the above action of booking periodic profits every year similar to equity.
However, using mutual funds for tax-efficient retirement planning is an excellent tool to create cash flows with minimal tax. Please see the following chart showing investment in a representative balanced fund.
Chart one shows an investment of Rs one crore in a hybrid fund. The investor is expected to hold the investment for one year to take care of zero exit load and to benefit from long term taxation. After investing the capital in January 2016, the investor withdraws Rs 60000 per month for his expenses. During the next five years, even after the withdrawals of Rs 36,60,000; his capital grows to 1,70,46,128. the beauty further is that the total tax payment is only Rs 70000, considering the basic exemption of Rs 1,00,000 every year.
What else does an investor want?
In summary, the investor has to look at the asset class of equity, either directly or through mutual funds, book periodic yearly profits whenever available and enjoy the concessional tax regime to create wealth and also for retirement planning.
Note - The example of the fund given is for illustration purpose and is not a recommendation.