LTCG tax on equity is unfair and can hit India’s growth story

The investment component in a Ulip works like a mutual fund but it comes bundled with a tiny layer of insurance, which is why it is guided by different tax rules

The most efficient way to reach a long-term investment goal is on the back of an inflation-beating asset such as equity. India’s affinity to equities is new-found and is growing, thanks to systematic investment plans (SIPs). Even the tax nudge was just right for equities until last year, when long-term capital gains (LTCG) tax for a holding period of more than a year was zero. So when the government reintroduced LTCG tax on equity after almost 14 years, it was quite a shocker. In 2018, the government announced a 10% tax on LTCG from equity (shares and mutual funds), though LTCG up to 1 lakh remains exempt.

Dhruv Mehta, chairman, Foundation of Independent Financial Advisors, said the move was counter-productive to some extent. “Last year has been tough for the mutual fund industry. The markets were volatile, there was re-categorization of schemes, regulations further tightened distributor fee and on top of that came LTCG tax on equity. The government also levied a dividend distribution tax. People invest in equities to create long-term wealth and if this income is taxed, it is a huge dampener," he said.

Srikanth Meenakshi, co-founder and former chief operating officer, FundsIndia.com, said the levy of LTCG tax did trigger a downturn. “Even now when you see the growth in SIPs, the rate is lower than what it was in pre-LTCG days," he said. He added, however, that levy of LTCG can’t continue to be a dampener in the long run as “the difference of return between equity and other fixed-income products is huge. But the tax arbitrage needs to go."

He was referring to an investment arbitrage vis-a-vis unit-linked insurance plans (Ulips) because maturity returns from Ulips are tax-free. The investment component in a Ulip works like a mutual fund but it comes bundled with a tiny layer of insurance, which is why it is guided by different tax rules. As per Section 10 (10D) of the Income-tax Act, if the sum assured in a life insurance policy is at least 10 times the annual premium, then the proceeds are tax-free. So when you invest in an equity fund in a Ulip, you pay no LTCG tax, but you pay a short-term capital gains tax of 15% in an equity-oriented mutual fund if you redeem within a year and 10% LTCG tax if you redeem after a year. But this is not the only point of discrimination that goes badly for a mutual fund.

Rajaraman Kumbeswaran, founder of iAspire, a mutual fund distributor, said tax arbitrage between products should go. “In Ulips, you can switch between funds without paying any tax but the same is not true for mutual funds," he said. “The other problem for investors is keeping track of capital gains tax. Mutual fund companies and brokerages can be asked to deduct capital gains tax and update the same in form 26AS," he added.

It will be tough for the government to achieve its target of becoming a $5 trillion economy without retail participation.