It is that time of the year again, when taxes are being planned and ‘tax saving’ instruments are selling like hot cakes. This seasonal pattern of buying tax savers only in the last quarter is one of the inexplicable investor behaviours.
For most salaried people, tax liability and cash flows occur uniformly throughout the year and ideally, investing in should form part of the plan. But more often than not, we end up investing in whatever is available at that moment, rather than trying to fit the tax-saving instrument in our portfolio.
I have come across investors with multiple tax saving instruments—bonds, equity-linked mutual funds (ELSS), single-premium policies, multiple unit-linked policies… all in one portfolio.
There is a tendency to forget that tax saving is just one of the features of the product, albeit an important one. More important are the returns and the risks with the product.
Most tax-saving instruments are at two ends of the risk-return spectrum—either very low-risk, low-return like Public Provident Fund (PPF) or insurance; or high-risk, high-return like ELSS (predominantly mid-cap oriented equity mutual funds).
So, these need to fit in the overall asset allocation. Maintaining the right asset allocation is possibly the most important determinant of portfolio performance in the long run. One way to go about it will be to do a simple cash flow analysis—ask your adviser to do it—and assess the benefit of the tax saving over the life of the investment.
But sometimes, cash flow analysis is based on the current scenario and does not take into account the changes that might happen over the next few years or account for the liquidity or risk with the investment.
Recently, I came across a column in which the author recommended buying a cheaper second home so that the unutilized tax break available on interest paid on equated monthly instalment (EMI) from the first home could be set off. So, if you have a sizable home loan of, say, ₹ crore, most of your EMI will be the interest component (about ₹ 80,000-90,000 per month).
Given that tax deduction on EMI interest has an upper limit of Rs2 lakh per annum, most of the interest will not be tax deductible. If you buy a second, much cheaper home, you can show the remaining interest as loss from home property, subject to certain conditions.
Sounds like a very profitable idea, and kudos to the mind that thought of it. But I will possibly never implement it because of the following reasons:
1. buying another house when I have no intention of using or renting it out—and is likely far from where I am currently residing—involves many other costs and hassles like maintenance and security;
2. the tax set-off rule could be reversed anytime—especially if too many people start using it—and I could be left with an illiquid asset. Since then, the recent Union Budget has plugged this loophole.
The world over, we are possibly seeing a move towards rationalizing tax structures—both for companies and individuals. The Indian finance minister has indicated this and the new US president made it a vital election issue.
Tax rates will likely be brought down but at the same time many exemptions will be removed.
For individuals in India, too, tax rates are likely to decline over the next 2-3 years, while multiple rebates and deductions will be reduced.
It is increasingly being realized that most exemptions are misused and do not serve their intended purpose. Tax havens are the biggest conduits for money laundering activities globally.
Even for equities, there is a high probability that equity and debt instruments will come at par with long-term capital gains tax.
This year we escaped the bullet but it could happen in the future. Either equity will attract long-term capital gains tax or the qualification period for long term will increase from 1 year to 3 years, as in case of debt.
Conceptually also, it makes sense as equity is a longer term instrument than debt and longer holding periods should be incentivized for equity instruments too.
But will that mean that equity attractiveness will come down? Maybe it will in the immediate term, and for a small segment of the population. But for the longer term and for majority of the investors, the wealth creation upside through equities remains the same.
Recently, I spoke with a college friend who now lives and works in the Cayman Islands. Obviously a huge advantage of living there is the zero tax on all incomes, and thus, huge savings potential. But a decision to live there will also depend on many other factors, though Cayman Islands is beautiful too. Ironically, the best places to live on earth for many years have been the likes of Scandinavian countries, Canada and Australia, which have the highest tax rates in the world.
A similar argument can be made for investment decisions too. Let tax saving be a guide, and not the decision maker. As Mark Twain said, there are only two things certain in this world and one of them is tax.
Atul Rastogi, Registered Investment Adviser and founder Ardawealth.com