New Tax Laws Will De-compound your returns

The tax on capital gains from long-term equity holdings, as proposed in the new version of the Direct Tax Code, will drastically reduce equity returns. This reduction will go far beyond the actual percentage of tax that will be paid. For example, over a ten year period, an effective tax rate of fifteen per cent could reduce a typical investor's returns by 50 per cent or so, and perhaps more, much more. If investors are to limit the damage, then they will have to understand how this tax will actually affect them, and how they can manage them.

How could a long-term capital gains tax rate of just 15 per cent cause far more damage to your returns? Simply because even a long-term investor would need to switch between investments at some point. You could choose the most suitable stocks for the long-term but at some point, you would need to sell some of your holdings simply because business conditions have changed and the stocks are not such a great choice any more. Today, as long as you have held a stock (or an equity mutual fund) for more than a year, your gains are tax-free and you can happily sell your holdings and put the money in another investment.

However, once long-term capital gains tax comes in, you will get a tax hit on the returns every time you do that. Consider a ten year investment that is yielding 20 per cent an year. In ten years an investment of Rs 1 lakh at this rate would grow to Rs 6.19 lakh. If the long-term capital gains are taxed at 15 per cent for your income bracket, you would end up with Rs 4.41 lakh post tax returns, an effective rate of return of 18.3 per cent. But if this investment was switched to a different share or fund just twice in those ten years, the final post tax return would be just Rs 2.24 lakh.

The real gains of long-term investments come from compounding of returns, and repeated taxation would have a strong de-compounding effect. This pattern of taxation would reward not long-term investment per se, but only being long-term in the very same investment. I'm not sure whether that would be such a good idea.

Hope this throws some light on the new DTC. Do let us know your views.

Thanks,

Dewang K. Mehta

DENIP Consultants Private Limited