How India’s financial system innovated with new tax rules

From 2004 to 2018, there was no tax on Long Term Capital Gains (LTCG) on equities. This also applies to equity MFs held for more than 12 months. In case of dividends, Dividend Distribution Tax or DDT was levied. However, the dividends paid net of this tax were tax-free in the hands of the investors. This allowed investors in the top tax bracket to reduce their tax outgo as the DDT was lower than the highest rate of marginal tax.

mutual fund bonus

Some Debt Mutual Funds declare ‘Bonus’ units from time to time. Some investors took advantage of these announcements to do ‘bonus stripping’. Bonus stripping is the act of buying units of a fund with the intent of earning bonus units and then selling the original units at lower prices. It is to use loss on sale of original units to set-off against other capital gains.

For example, an investor named ‘X’ bought 500 units 100 each immediately before the record date of issue of bonus of 1:1. After the bonus issue, X has 1,000 units and the price of these units will be 50 each; Post bonus issue the unit price of the fund falls in the same proportion as the bonus units issued.

In case of bonus stripping, X will sell the original 500 units After releasing the bonus each decides to use a loss of 50 more 25,000 [500*( ₹100 – ₹50)] To be set off against other capital gains. The remaining units acquired at bonus can be sold only after one year and avail the LTCG exemption available. This scenario was applicable for the period prior to 2018. Even after 2018, when the LTCG tax exemption on equity was removed, it was still beneficial as gains in excess of profits were taxed at a concessional rate of 10%. 1 Lac. However, a few years back, the government had introduced a provision that did not allow such set-off of losses by way of bonus stripping.

Dividend

Dividend stripping is a concept similar to bonus stripping, where users intend to profit from capital losses incurred on the sale of shares or units at a lower price.

The concept became popular when dividends were exempt in the hands of shareholders. But not anymore, as such income is taxable at the applicable slab rate of the individual and makes the tax planning less effective.

When dividends were tax-free for shareholders (from 2003 to 2016), dividend plans from mutual funds were a preferred option for those looking for periodic income. In some cases such mutual funds were sold to investors as a way to receive regular income through dividends. But in Budget 2016, 10% tax on excess of dividend income 10 lakh per annum was introduced. Budget 2020 made entire dividend income taxable.

Now, Systematic Withdrawal Option (SWP) which also provides regular income to MF investors is better than using dividends for regular income. This is because each withdrawal is subject to capital gains tax treatment that is advantageous compared to the tax on dividends, especially for those in higher tax brackets.

ltcg

Tax exemption on LTCG in Budget 2004 made investors look favorably on equity as an asset class. It became more attractive when the tax regime for debt funds was changed in Budget 2014. In this budget, the qualifying period for LTCG in debt mutual funds was increased from 1 year to 3 years. For Equity MF, the same period was 1 year. Mutual fund houses innovated by launching categories such as arbitrage funds, which were equity funds for tax purposes, but practically functioned like debt funds through the use of hedging vehicles such as futures and options.

Hence, investing in arbitrage funds for the short term (1-3 years) is more tax efficient than investing in debt funds. Categories such as Equity Savings Fund and Balanced Advantage Fund make more limited use of the tax efficiency of equity, acting as debt funds.

Outside the mutual fund space, market-linked debentures (MLDs) – structured products that invest in both fixed-income and derivatives instruments – also gained traction among high net-worth individuals. Similar to equities, listed MLDs are taxed at 10% after a holding period of 1 year. But many MLDs are similar to regular bonds with only minor equity linkage.

Not all new offerings driven by changes in tax rules are disabled. However, it is not advisable to invest just for the tax benefits. It is important to examine the suitability of an investment product for one’s own risk profile and how it fits into the overall portfolio.