Smart Tax Guide

It's tax season again and like everyone else, you too feel that you're paying the government much more than what you should. Through the 'Smart Tax Guide' series, Value Research tries to answer tax-related questions that may be bothering you.

Q. From the tax point of view, how do equity funds compare with direct equity investing?
A. The key to a mutual fund's tax efficiency is the fact that it does not pay taxes on the gains its investment fetches. Compare two situations where an investor is enjoying benefits of an actively-traded portfolio—one, where an investor trades directly in stocks or other securities; and two, where an investor invests in a mutual fund.

When an investor trades directly, he or she has to pay a tax on gains for every transaction. An actively-traded portfolio is likely to have many transactions that involve selling securities that were held for less than a year. For tax purposes, such gains are classified as short-term capital gains and do not get any special treatment. Instead, these gains are added to the investor's taxable income for the year. If you are in the highest income slab and earn less than Rs 8.5 lakh per annum, then any additional income you earn gets taxed at full 30 per cent rate. If you earn more than Rs 8.5 lakh annually then you will be taxed at 33 per cent (30 per cent with an additional 10 per cent surcharge). In the worst case, active trading in units may be classified as business activity that requires elaborate book-keeping and audit besides higher tax.

However, none of this happens when active management of an investor's portfolio is done by a mutual fund. A fund can buy and sell securities at will, regardless of the holding period. The gains from such transactions aren't taxed at all. All the taxation is done when the investor himself sells the units and actually realises gains. In practice, this means that gains that an investor's money makes may get effectively converted—for tax purposes—from short-term or business income to long-term. This makes mutual funds an inherently tax-efficient vehicle.

This year, the Budget, however, proposed that equities acquired after March 1, 2003, will not be subject to long-term capital gains tax if held for a period of one year or more. From a tax viewpoint, buying equities for the long-term is thus the most tax-efficient investment. This obviously implies that you make a profit on your investment and have an idea about stocks.

As compared to this, equity mutual funds continue to be subject to a long-term capital gains tax of either 10 per cent or 20 per cent after being adjusted for inflation. So, from a long-term viewpoint, direct investing in equities seems more attractive.

Equity funds, however, can distribute dividends, which are tax-free in the hands of investors. These funds also don't have to pay any dividend distribution tax and so there is no tax incidence whatsoever in the dividend option. However, the quantum and timing of dividends is not at the discretion of investors.