Photo: iStock
Photo: iStock

The tax bark is worse than its bite

If an equity investment merits a home in your portfolio, you must include it, whether it offers tax benefits or not

Leo, my four-year-old golden retriever, is an utterly lovable, sociable, cheerful dog. He is also the most untrainable dog in the world. Anyone who visits us is pinned to the wall by the 50kg Leo and his slobbering tongue. His parents danced on their hind legs, balanced a ball on their noses, and won top prizes at dog shows. Those genes missed a generation. Leo specializes in dropping every catch during our Sunday cricket matches. 

So, we got our bumbling Leo a dog trainer. To my bewilderment, Leo turned from junglee (wild) to genial within a week. Then the trainer let me in on his secret. He said he wasn’t training the dog, he was training me all along. Without my realizing it, the trainer subtly changed the balance of power in my favour, and instead of Leo controlling me, I was now controlling him. 

So where is all this leading to, you wonder. Bear with me. Long-term capital gains (LTCG) tax has made an unwelcome comeback and is making investors rethink their investments in equity. Such behaviour is very much like Leo controlling me instead of the other way around. Like the tax tail wagging the investment dog, something relatively secondary is driving primary life goals and influencing investment decisions. 

A deeper analysis of LTCG tax proves that it will not have a substantial impact on returns, particularly if you hold on to the investment for a long period. The impact is highest in the first few years, and minimal in subsequent years. Even though the tax rate is 10%, the returns lost are always less than 10%. Consider an investment of Rs10 lakh. For a pre-tax return of 15%, you would think a reduction of 10% would result in a post-tax return of 13.5%.  However, that is not the case. The lowest post-tax return is 13.92% in the fourth year and as high as 14.31% if held for 15 years. 

Taxes come with the territory when you are earning and investing. If you’re earning a decent income, or investing and generating returns on your money, you will likely be subject to some form of tax or the other—be it income, capital gains, dividend or transaction tax. Of course, you want to pay lesser tax, and being tax-efficient is critical in creating long-term wealth. But the problem arises when you let the tax rules excessively dictate your investment decisions. 

Soon after the Budget, a client asked me if we should sell his equity investments and reinvest in a unit-linked insurance policy (Ulip) instead, so he could avoid future taxes on the gains. This logic is completely flawed because you never know how tax rules will impact insurance policies in the future. Second, you are tied to the performance of the Ulip’s funds and lose your flexibility to exit underperforming funds. Third, Ulips don’t come free of charges. Apart from upfront costs, there are ongoing costs like fund management and mortality charges. This mortality cost increases each year as you age. If you don’t need life insurance, you do not need to incur this cost. You’d be better-off investing in a more flexible, transparent, and cost-effective product even though you may pay a bit more in taxes. An obvious example of investments where tax benefits override investing prudence are traditional life insurance policies. With neither high returns nor high insurance cover, investors still throng to buy such policies, especially towards the financial year-end, just to close their section 80C tax gap. What investors do not check are the underlying assets in such schemes, the kind of returns they would generate during their tenure, whether the returns would beat inflation in the long run, their cost structures and surrender charges, and whether such policies would provide a meaningful life cover. When the product becomes secondary to tax benefit, it results in a poor investing experience. 

Another example is setting-off capital gains against capital losses. You incur a loss when you buy high and sell low. When you keep doing this frequently and deliberately set off losses against gains, you are hurting the growth of your portfolio. You may end up selling a good investment before time, thereby defying the very principles of wealth creation—which are buying low, selling high and holding on to good investments. To prevent yourself from making irrational investment decisions that are primarily based on tax advantages, you must ask yourself the following questions: What are the risks of the investment? Do the tax benefits justify the risk? What are the potential returns from the investment? Are the returns attractive even without the tax benefit? Would the investment help meet a definite need in a meaningful manner? Would the investment still be attractive without the tax benefit? 

Taxes come into play in a tactical way in the short term. Say, when you want to redeem an investment. You should evaluate your portfolio for underperformers and determine which ones to exit. If it means holding on to funds for a few more days or months to avoid higher short-term tax when you could have paid a lesser long-term tax, then it makes sense to wait it out. A change in the tax structure does not mean that you rejig your overall plan. You can’t control the tax laws, but you can control your financial plan. Stay focussed on your long- and short-term goals and stick to the right asset allocation. If an equity investment merits a home in your portfolio, you must include it, whether it offers tax benefits or not. Else, you may choose the wrong investment, which may save you taxes, but may perform poorly for you. 

I’m getting better at establishing myself as the master with Leo. My neighbour still complains that Leo knocks her down senseless at least twice a day. But when she’s ringing our doorbell countless times for oil, sugar, yogurt or some such, I don’t have much sympathy. Let’s just say it’s a bone of contention between us. 

Priya Sunder is director and co-founder of PeakAlpha Investments.

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