A long-term investing strategy in equities will beat returns from traditional instruments.
For decades, Indian investors have been following haphazard investment strategies, which expectedly, rarely gave results as envisaged by them. The scenario has changed over the last few years. Realising the need to plan their investments for achieving their long-term investment goals, many investors have started looking for risk profiled long-term solutions to optimise the portfolio returns. Consequently, equities have begun to play an important role in the portfolio composition.
The ever increasing number of investors investing in equity funds through a Systematic Investment Plan (SIP) is a testimony of this emerging trend. Needless to say, the prevalent tax provisions too contributed a great deal to this.
While the process was gathering momentum, the draft Direct Tax Code (DTC) announced by the government of India in 2009 came as a shock as it proposed a change in the tax regime from exempt-exempt-exempt (EEE) to exempt-exempt-taxed (EET). Expectedly, the first draft drew criticism from many quarters and the government had to come out with a revised draft of the DTC last week, addressing some of these concerns.
In a major turnaround, the government has restored the EEE status for Government Provident Fund (GPF), Recognised Provident Fund (RPF), Public Provident Fund (PPF) and pure life insurance products as well as annuity schemes. Besides, the New Pension Scheme (NPS) has been granted the EEE status.
Thankfully, the proposed provisions relating to capital gains too have been amended. While the original provision eliminating distinction between short-term and long-term investment asset depending on the basis of length of holding of the asset remains, capital gains arising from the sale of an investment asset held for more than one year shall now be computed after allowing a deduction at a specified percentage of capital gains without indexation. The adjusted capital gains will be included in the income of the tax payer and then taxed at the applicable rate.
The discussion paper gives three illustrative examples using rates of 50, 60 and 70 percent while clearly stating that the specific rate of deduction for computing adjusted capital gains will be finalised in the context of overall tax rates. For the sake of understanding, let us take 50 percent as the effective deduction and see how the DTC provisions could impact the returns of a long-term investor in the highest tax bracket.
For example, an investor who invests Rs.5000 per month for 10 years in an equity fund through SIP would receive an amount of Rs 11,09,650, assuming an annualised return of 12 percent. While as per the current tax laws, he would pay zero tax on the capital gains of Rs 5,09,650, under the DTC he will have to pay a tax of Rs 76,447 at the rate of 30 per cent on the reduced capital gains of Rs 2,54,825. The effective rate of tax would work out to be 15 percent.
The same investor can reduce his tax liability by investing for the longer term, say 20 years, so as to ensure that SIP gets completed after he retires. As the income levels generally go down after one retires, he could end up paying tax on the capital gains at an effective rate of 5 or 10 percent.
The important point here is that since equities have the potential to give better returns over the longer term ( good quality equity funds have given an annualised return in excess of 15 percent over the last 15 years), in all likelihood his post tax returns would still work out to be much superior than options like PPF. Hence, investors need to keep faith in equities to build wealth over the long-term and not change allocation to this asset class.
One way to reduce the impact could be to plan for a very long term. This would require an investor to not only plan his investment strategy properly but also select investment options carefully to avoid making changes mid-way. In reality, achieving this can be quite a challenge for investors.
The writer is CEO, Wiseinvest Advisors
