The big announcement in the Union Budget 2018 was the introduction of tax on long term capital gains (LTCG). The LTCG tax has been imposed at the rate of 10% if the capital gain for the financial year exceeds Rs.1 lakh. This will be calculated by aggregating the capital gains from equities and from equity funds. Remember, we are referring to long term gains only. Short term capital gains will continue to be taxed at the current rate of 15%. Additionally, also remember that this tax on LTCG will be in addition to the securities transaction tax (STT), which will continue to be charged at the current rates. Also there will be no benefit of indexation available on this tax on LTCG. So whether you earn capital gains after a holding period of 1 year or 10 years, you will end up paying 10% of the profit to the government as LTCG tax.
So if you want to know how the budget affected ELSS funds; that is how it is. But our understanding of the impact is still too intuitive. Let us understand the impact of budget on ELSS funds in a more comprehensive manner and also let us understand if the relationship between budget 2018 and ELSS schemes is really that negative as is made out to be.
How the annualized returns on ELSS get impacted by the LTCG tax..
The big advantage on ELSS is the benefit of Section 80C that is available on these instruments. Assuming that you are in the 30% tax bracket, the ELSS gives you a 30% tax break. For simplicity we will keep the tax rate at 30% and ignore the impact of surcharge and the cess. Also let us assume that the LTCG limit of 1 lakh for the financial year 2018-19 is not yet utilized..
ParticularsAlpha Equity FundParticularsAlpha ELSS FundNature of the FundEquity Diversified FundNature of the FundTax Saving FundLock In PeriodNot applicableLock In Period3 YearsNAV on 1st May 2015Rs.10NAV on 1st May 2015Rs.10Number of Units10,000 unitsNumber of Units10,000 unitsCost of InvestmentRs.100,000Value of InvestmentRs.100,000Section 80C BenefitNot ApplicableSection 80C BenefitRs.30,000 (at 30%)Effective InvestmentRs.100,000Effective InvestmentRs.70,000 NAV on 3rd May 2018Rs.33NAV on 3rd May 2018Rs.33Value of InvestmentRs.3,30,000Value of InvestmentRs.3,30,000Capital GainsRs.2,30,000Capital GainsRs.2,30,000Effective Capital GainsRs.2,30,000Effective Capital GainsRs.2,60,000Annualized Yield48.89%Annualized Yield67.71%Exempt ProfitRs.1,00,000Exempt ProfitRs.1,00,000Taxable ProfitRs.1,30,000Taxable ProfitRs.1,30,000Tax at 10%Rs.13,000Tax at 10%Rs.13,000Effective Net Profit2,17,000Effective Net Profit2,47,000Effective Annualized Yield post-tax46.90%Effective Annualized Yield post-tax65.45%
# Note – We have ignored surcharge and cell on tax in our calculations to keep the overall idea simple
As we can see in the above table, the impact on the equity fund and the ELSS fund due to the introduction of the tax on LTCG is less than 250 basis points. That is hardly anything that is really disconcerting. Therefore, to believe that investors will sell out of ELSS due to the impact of tax is highly specious. Even after you consider the impact of the LTCG tax on the ELSS fund, its effective returns are substantially higher than what you can reasonably earn on other Section 80C products like PPF and long term FDs. So the attractiveness of ELSS is unlikely to be diminished due to the tax on ELSS.
There is also the benefit of loss set-off and carry forward available..
The advantage of taxing long term capital gains is that logically the long term losses will be available for set-off against profits and also for carry forward for a period of 8 years. In the above case of the ELSS, there is a taxable LTCG of Rs.1,30,000 after the exemption limit is availed. Let us assume that you already have a long term capital loss available to the extent of (Rs.2,45,000) from sale of other assets. Now out of these losses, you can set off Rs.1,30,000 profits on LTCG and the balance (Rs.115,000) loss can be carried forward for a period of 8 years. So, next year when another ELSS matures then you have the balance loss of Rs.115,000 already available to you for a set-off. That is another big advantage of the introduction of LTCG tax which you cannot ignore.
Does the Union Budget change the pitch for ELSS?
To cut a long story short if the ELSS in India gives an effective annualized yield of 25%, then it will come down to around 23%, which is still a very attractive rate on tax saving products. In addition, if you have losses from other assets, then you can set off against these profits and also carry forward these losses for 8 years. When you combine these two factors, the net impact on ELSS is unlikely to be really negative. The attractiveness of ELSS as a robust tax saving option should continue as before!