How debt funds compare with equity funds on LTCG - Motilal Oswal
How debt funds compare with equity funds on LTCG - Motilal Oswal

How debt funds compare with equity funds on LTCG

In the Union Budget 2018, the government of India introduced a new provision wherein equities and equity funds will also be taxed at a flat rate of 10% on their long term capital gains. Remember, LTCG on equity funds was tax free in the hands of the investor till the fiscal year 2017-18. Here are some of the key provisions that the latest Budget has put forth and why it is important for investors:

Long term capital gains (LTCG) on equities and equity funds will be taxed in the hands of the investor in the year the gains are realized. While LTCG up to Rs.1 lakh per year will be exempt, any gains beyond that will be taxed at a flat rate of 10%.

The important point to note here is that the tax on LTCG is a flat tax which means that the benefit of indexation is not available. This is particularly relevant when equity fund are held over a longer time frame.

Apart from taxing LTCG, the budget has also imposed dividend distribution tax (DDT) on equity funds. When a fund pays out dividend, it will deduct 10% DDT and only pay out the net amount. This is to put equity funds at par with equities which attract tax at 10% in the hands of the investor when the annual dividend exceeds Rs.10 lakhs.

Let us look at an equity fund LTCG after the budget announcement
In this table, we look at how the LTCG impacts the gains of an investor in an equity fund before and after the LTCG Tax.

Pre-LTCG TaxAmountPost-LTCG TaxAmountDate of InvestmentJan 01st 2012Date of InvestmentJan 01st 2012Investment CostRs.6,00,000Investment CostRs.6,00,000Date of saleFeb 05, 2018Date of saleApr 05, 2018Sale ValueRs.15,00,000Sale ValueRs.15,00,000Capital GainRs.9,00,000Capital GainRs.9,00,000Tax on Capital Gain-Nil-Exempt Capital GainRs.1,00,000Post Tax LTCGRs.9,00,000Taxable Capital GainRs.8,00,000  Tax on LTCG (10%)Rs.80,000  Post Tax LTCGRs.8,20,000

 
As we can see from the above table the tax on LTCG is significantly reducing the post tax capital gains on equities and equity funds. This has larger implications for your financial plan. That is because, when you realize your capital gains at the time of your milestones, you will be paying nearly 10% as LTCG tax. That is something you need to seriously factor in. But the bigger question is does this tax change the attractiveness of equity funds vis-à-vis debt funds. Let us look at a comparison of the two.
 
Post LTCG; how to equity funds and debt funds compare?

One can argue that equity funds and debt funds are not exactly comparable as they are different products altogether. That is not the point. The real point to note is that debt funds get the benefit of indexation while equity funds do not. How does that change the equation? Let us look at a live illustration with a five year time frame.

 

Debt FundAmountEquity FundAmountDate of InvestmentMay 01st 2013Date of InvestmentMay 01st 2013Amount InvestedRs.10,00,000Amount InvestedRs.10,00,000CAGR Yield12%CAGR Yield12%Date of RedemptionMay 01st 2018Date of RedemptionMay 01st 2018Redemption ValueRs.17,62,342Redemption ValueRs.17,62,342Capital GainsRs.7,62,342Capital GainsRs.7,62,342Indexed Value of purchase (284/220)Rs.12,90,909Exempt LTCGRs.1,00,000Indexed LTCGRs.4,71,433Taxable LTCGRs.6,62,34220% tax on LTCGRs.94,286LTCG Tax at 10%Rs.66,234Post Tax LTCGRs.6,68,056Post Tax LTCGRs.6,96,108

 
While the equity fund has still done better than the debt fund in post tax terms, the LTCG benefit of equity funds is diminishing. Here are 2 points that logically follow:

The above equation would have been strongly weighted in favour of equity funds had the 10% tax on equity fund LTCG not existed. That has largely taken away the tax attractiveness of equity funds vis-à-vis debt funds in the long run.

For simplicity, we have assumed that the equity fund and the debt fund generate the same return, which is not the case in reality. The message is that now equity funds will have to sharply outperform the debt fund returns to compensate for the loss of tax benefits on equity funds.

While equity funds still remain the best way to generate wealth in the long run, this 10% tax on LTCG has surely taken some charm away from the tax benefits of equity funds.
 

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