New Direct Taxes Code - not so friendly on investments

The revised discussion paper on the new direct tax code has a couple of provisions that would mean a fundamental change for those investing in stocks, equity mutual funds and other equity-based asset types.



The biggest change is that long-term investments in such assets will no longer be tax-free. Even though there has been a great deal of public comment on the unfairness and inappropriateness of this change, the tenor of the draft code and the two discussion papers is quite clear. Taxation on long-term equity returns is coming and investors will just have to live with it. It’s interesting to see that the actual percentage of taxation will be linked to the investors’ own income level.

Will this have a major impact on equity investors? Despite the initial reactions that you may hear or read, I don’t think this tax will actually impact people’s equity investing behaviour. Mind you, I’m not going here into the issue whether this tax is unfair or unjustified. I’m just saying that it probably won’t affect long-term investor behaviour. All the protests you hear about equity returns taxation are from people who are short-term investors and do not understand how long-term works.

Basically, there are two reasons. The facetious one is that tax is choice and you don’t have a choice. But the other is more interesting. The way the arithmetic of long-term investing works, such a tax will encourage long-term investing far more than a simple zero-tax does now. Here’s how it works. Currently, the moment your holding crosses a 365 day period, the returns become zero tax, whether you redeem your investment the next day or after ten years.

However, if long-term gains were taxed at whatever rate, then selling your investment, even to reinvest it would carry a returns hit. Consider a ten year investment that is yielding 20 per cent an year. In ten years an investment of Rs 1 lakh at this rate would grow to Rs 6.19 lakh. If the long-term capital gains are taxed at 15 per cent, you would end up with Rs 5.41 lakh post tax, an effective rate of return of 18.3 per cent.

Compare this to another investment that earns at the same rate overall, but is switched to a different share or fund just twice in those ten years. Each time the money is redeemed to be reinvested, tax has to be paid on the returns generated till that point. Because the real gains of long-term investments come from compounding of returns, this shrinkage of the amount that is available for compounding has a major impact on eventual returns. In our hypothetical investment above, just two sell-and-reinvest cycles in ten years reduce the final post tax amount from Rs 5.41 lakh to Rs 3.24 lakh. Instead of earning at 18.3 per cent, your returns would be just 12.5 per cent.

This de-compounding effect of repeated taxation would actually be the biggest impact of the new tax code on equity investing. Over a long period of time, individual investments can lose their suitability and attractiveness. This can make long-term investments in equity relatively less attractive even if you are a good stock-picker. For investors, the best solution would be to invest in generalised equity fund that would have the flexibility to switch to any kind of stocks as conditions changed over a long period.

The new tax code will enforce some fundamental changes in the way taxation works and the full impact of these will be understood only gradually

By Dhirendra Kumar