If you think equity fund-of-funds are not tax efficient, think again!

Posted On Thursday, Jun 20, 2019


Fund-of-funds which invest in other equity funds are treated as debt funds for taxation in spite of their underlying asset class being equity. Isn’t that Ironic?

Accordingly, for a holding period of less than three years, gains are treated as short term, added to your income and taxed as per your applicable tax slab; for a holding period of more than three years, capital gains are taxed at 20 per cent after indexation.

Fund TypeHolding period for long termShort termLong term
Equity fund1 year15%10% with exemption up to Rs 1 lac per year
Debt fund3 yearsslab rate20% with indexation

This put the category at a major disadvantage, and was thus not preferred by investors looking to invest in equity funds.

We at Quantum have for long tried to persuade the finance ministry to correct this incorrect taxation system, but there has been no positive development yet.

But Budget 2018 changed things for this category. With the 10 per cent long-term capital gains (LTCG) tax on equity funds introduced in February last year, investment in Fund of funds have now become more attractive. Let’s understand how.

1) For an investment horizon of three years and above, effective debt taxation could be as or more attractive due to indexation benefits, which have not been provided in case of equity taxation.

With indexation, you are allowed to adjust the cost price of your asset for inflation using a government provided inflation factor (CII). This helps to counter erosion of value in the price of an asset due to inflation, and attempts to bring the value of an asset relatively closer to prevailing market prices. This thus reduces the net taxable gain allowing you to pay lower capital gains tax.

As in the case below, for a period of 3 years and above, due to inflation adjustment of purchase price done in the debt taxed product, the tax on capital gains is as much as the tax on gains in the equity product. (All tables are for illustrative purpose only)

Purchase2014-15Rs 12 lacs240
Sale2018-19Rs 15 lacs280

Actual Capital Gains = 15 lacs- 12 lacs = 3 lacs
New Purchase price after INDEXATION = 12 lacs x 280/240 = Rs 14 lacs
New Capital Gains (after Indexation benefits) = 15 lacs- 14 lacs = 1 lac
Tax @ 20% = Rs 20000

Purchase2014-15Rs 12 lacs
Sale2018-19Rs 15 lacs

Capital Gains = 15 lacs – 12 lacs = 3 lacs
Exemption = 1 lac

Scenario 1: 1 lac exemption available
Taxable capital gains = 3 lacs – 1 lac = 2 lacs
Tax @ 10% = Rs 20000 (which is equal to debt taxation)

Scenario 2: 1 lac exemption already exhausted
Taxable capital gains = 3 lacs
Tax @10% = Rs 30000 (which is more than debt taxation)

2) Another important thing to keep in mind is that without the inflation adjustment, you could be effectively paying much more than 10% tax on your equity gains in spite of the 1 lac exemption. Let us illustrate with an example.

Purchase price of equity asset (a)Rs 50 lacs
Sale price of equity asset (b)Rs 55 lacs
Return on equity asset (c)10%
Capital gains (d)Rs 5 lacs (b – a)
Tax paid @10% on gain after Rs 1 lac exemption (e)Rs 40000 (10%*d less exemption of Rs 1 lac)
Rate of inflation (f)6%
Real rate of return (g)4% (c-f)
Purchase price after adjusting for inflation (h)Rs 53 lacs (a*f)
Real gain (i)Rs 2 lacs (b-h)
Effective tax rate (j)20% (e/i)

As seen above, the nominal rate on equity gains is 10%, but effectively the investor pays 20% as there is no adjustment to purchase price on account of inflation.

3) Consider an investing period where your returns are 8% and the inflation is 10%. For asset classes like debt and real estate that enjoy indexation benefits, there would be no tax in this case. However, in equity products, you would have to pay tax even though you have made an effective loss as your real return is negative.

4) A FoF will be a more efficient way to move in and out of mutual fund schemes

Since capital gains would be taxed on each switch from one mutual fund scheme to another, you will have less capital being reinvested and compounding every time you switch schemes. The eventual impact of this on your corpus would be quite large.

However, when the Equity FoF manager exits an underperforming scheme and buys into a better performing one, mutual funds being pass through vehicles - he isn’t liable to pay any tax on the gains, thus keeping your capital intact for reinvestment.

This is something investors do not take into account when considering a FoF, instead focusing only on the bit which taxes the Equity FoF like a debt fund.

But at the end of the day, taking an investment decision solely based of the tax considerations could be counterproductive. We recommend you choose your equity investments after a thorough understanding of risk, return, liquidity and other considerations. Even if tax is a bigger consideration for you, Equity Fund of Funds works in your favour!

Product Labeling
Name of the SchemeThis product is suitable for investors who are seeking*Riskometer
Quantum Equity Fund of Funds

(An Open Ended Fund of Funds scheme Investing in Open Ended Diversified Equity Schemes of Mutual Funds)
• Long term capital appreciation

• Investments in portfolio of open-ended diversified equity schemes of mutual funds registered with SEBI whose underlying investments are in equity and equity related securities of diversified companies
Quantum Long Term Equity Fund
Investors understand that their principal will be at Moderately High Risk
* Investors should consult their financial advisers if in doubt about whether the product is suitable for them.

Disclaimer, Statutory Details & Risk Factors:

The views expressed here in this article / video are for general information and reading purpose only and do not constitute any guidelines and recommendations on any course of action to be followed by the reader. Quantum AMC / Quantum Mutual Fund is not guaranteeing / offering / communicating any indicative yield on investments made in the scheme(s). The views are not meant to serve as a professional guide / investment advice / intended to be an offer or solicitation for the purchase or sale of any financial product or instrument or mutual fund units for the reader. The article has been prepared on the basis of publicly available information, internally developed data and other sources believed to be reliable. Whilst no action has been solicited based upon the information provided herein, due care has been taken to ensure that the facts are accurate and views given are fair and reasonable as on date. Readers of this article should rely on information/data arising out of their own investigations and advised to seek independent professional advice and arrive at an informed decision before making any investments.

Mutual fund investments are subject to market risks read all scheme related documents carefully.

Please visit – www.QuantumMF.com to read scheme specific risk factors. Investors in the Scheme(s) are not being offered a guaranteed or assured rate of return and there can be no assurance that the schemes objective will be achieved and the NAV of the scheme(s) may go up and down depending upon the factors and forces affecting securities market. Investment in mutual fund units involves investment risk such as trading volumes, settlement risk, liquidity risk, default risk including possible loss of capital. Past performance of the sponsor / AMC / Mutual Fund does not indicate the future performance of the Scheme(s). Statutory Details: Quantum Mutual Fund (the Fund) has been constituted as a Trust under the Indian Trusts Act, 1882. Sponsor: Quantum Advisors Private Limited. (liability of Sponsor limited to Rs. 1,00,000/-) Trustee: Quantum Trustee Company Private Limited. Investment Manager: Quantum Asset Management Company Private Limited. The Sponsor, Trustee and Investment Manager are incorporated under the Companies Act, 1956.

Above article is authored by Quantum.

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