LTCG – Grandfathering and impact on ELSS – Budget 2018-19

In the recent union budget presented on 1st, February 2018, Finance Minister introduced the anticipated LTCG tax of 10% on gains of greater than ₹. 1 Lakh arising from sale of listed securities. While this came as a blow to investors, the blow was softened by the Grandfathering Clause to protect existing investors. Let us understand the implications of this new tax.

LTCG

LTCG Stands for Long Term Capital Gain. It is the profit made on any security, fund or commodity held by an investor for more than a year.

LTCG Tax refers to the tax the government has imposed on the profit or return made on such an investment. However, LTCG tax is only applicable if the return amount is more than ₹. 1 Lakh. The tax will be computed on the gains without providing the benefits of indexation, which links the acquisition price with the inflation index.

Grandfathering Clause

Another important announcement made in the budget regarding the LTCG Tax was the Grandfathering Clause that is associated with it. All investments made before 1st February 2018 will not incur any tax and the value of the holding as on 31stJanuary 2018 will be considered as the Cost of Acquisition for gains calculation.

The announcement and subsequent clarifications also mention that for calculation of gains the cost of acquisition, will be the higher of the two prices, namely, the price at which the holding was purchased before 1st February 2018 or the market price of the holding on 31st January 2018.

Equity Mutual Fund

Example:

Rahul invested ₹1,000, 000 in Franklin High Growth Companies Fund – regular on 20th Sept 2016 at a NAV ₹32.058 and got 31193.5 units. On 31stJanuary 2018, the NAV of Franklin High Growth Companies Fund – regular was ₹41.8594. The value of his holding on 31st Jan 2018 was ₹1,305,740 an absolute return of 30%. If Rahul redeems his units and books profit/gain on 1st February 2018, he shall not be liable for any capital gains tax.

However, after 1st April 2018, say Rahul wants to redeem his investment in Franklin High Growth Companies Fund – regular and assuming the future NAV as on that date is ₹50.00, the amount he will receive shall be ₹1,559,675, the total absolute return of 55.96%, the capital gain tax shall be calculated as below;

Gain: from 20th Sept to 31st Jan 2018 = ₹305,740 (absolute return 30.5%)

Tax: 0% (Grandfathering)

Gain from 31st Jan 2018 to 1st April = 31193.5 x (₹50 – ₹41.8594) = ₹253,933.8 (absolute return 25.39%)

Tax on Gain: 10% x (₹253,933.8 -₹ 100, 000) = ₹15,393.38

Total Gain: ₹559,670.0

Net Gain after tax: ₹544,276.00 (absolute return 54.4%)

So, the return in above case has come down from 55.96% to 54.4%, a mere reduction of 1.56% due to capital gain tax. The 4% cess is not shown in above calculation the tax percentage under LTCG is 10% and 4% cess which makes the total taxable rate as 10.4%

Debt Mutual Funds

There is a small respite though for people investing in debt Mutual Funds as LTCG only applies to equity- oriented funds which hold more than 65% of assets in equities. Also, there is no change in debt fund taxability.

For debt-oriented mutual funds, there is no change in the taxation structure compared to what was prior to the budget. Short term capital gains (STCG) are computed on gains of maximum 3 years and are taxed as per the individual’s income tax slab. Long Term Capital gains (LTCG) are taxed at 20% if held for over 3 years and after adjusting for indexation. Along with this an additional cess on the LTCG is applicable at 4%. This renders the total taxation on debt-oriented equity funds to 20.8%.

Long Term Capital gains tax around the world

Different countries have different taxation when it comes to capital gains. Some countries like Australia and Canada tax individuals on capital gains at the same percentage as they tax them on their respective income tax slabs.

The USA imposes a tax rate of 0% for income up to $37,950. Its highest rate of 20% only kicks in for incomes of $418,401 and above (equal to about ₹ 2.66 crore).

The UK imposes an 18% capital gains tax on incomes below GBP 43,000 and 28% for higher income. However, it also separately provides a tax-free capital gains allowance of GBP 11,300. Canada exempts 50% of the gain from tax but taxes capital gains as per the applicable slab.

Different countries approach capital gains differently. Many impose higher rates on higher slabs than India’s highest slab, but lower rates on lower slabs than India’s. Others offer a tax-free allowance. Thus, relying on a headline rate comparison may not give you an accurate picture.

*For the highest tax slab. Taxes go from 0% to 20% depending on the tax slab.

**With gains up to 31st January 2018, grandfathered

***For highest slab. Capital gains allowance of GBP 11,300 given.

****50% of gain exempted

Comparison with other schemes

The new LTCG Tax could change the way individuals prefer to invest their savings. For example, Equity Linked Saving Schemes (ELSSs) having lost their tax-free status will be looked at as a less favoured option for investors looking to save tax. The LTCG tax will make tax-saving options like Public Provident Fund (PPF) and ULIPs comparatively more tax efficient than other equity linked funds as they continue to be tax free. Also, given that equity funds will not be allowed indexation benefit, while debt funds still enjoy indexation, the tax disparity between equity and debt has narrowed, making debt funds and Fixed Maturity plans (FMP) more attractive now.

But such a conclusion is inequitable when the entirety of the situation is considered. Although ELSS funds will now be taxed at 10%, they still have the potential to yield higher post-tax return. Being purely equity-based instruments, ELSS funds have the potential to generate higher returns, making them an ideal long-term investment, irrespective of the new tax.

Low cost Unit Linked Insurance Plans (ULIPs) can possibly provide returns comparable with ELSS over the long term. But unlike ULIPs, ELSS offer greater flexibility wherein, the investor does not have to make multi-year commitment and can shift to another fund if a scheme is not performing. While on the other hand, for ULIPs, the investor can only shift between the funds offered by that ULIP. Moreover, since ELSS fall under section 80C, they offer tax deduction of up to ₹. 1.5 Lakhs. Hence, ELSS will remain as a good option under the 80C basket for long term wealth creation.

If saving tax is the goal, then under 80 C, ELSS can still help achieve it better than other alternatives.