If you think equity fund-of-funds are not tax efficient, think again! 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 Type||Holding period for long term||Short term||Long term|
|Equity fund||1 year||15%||10% with exemption up to Rs 1 lac per year|
|Debt fund||3 years||slab rate||20% 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)
|Purchase||2014-15||Rs 12 lacs||240|
|Sale||2018-19||Rs 15 lacs||280|
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
|Purchase||2014-15||Rs 12 lacs|
|Sale||2018-19||Rs 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!
|Name of the Scheme||This 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
Investors understand that their principal will be at Moderately High Risk
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