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Short Term Capital Gains Tax On Equity Mutual Funds Until 3 Years… So What?

All those balking at the prospective changes to the Long-Term Capital Gains (LTCG) norms on Equity Mutual Funds need to ask themselves just why they're so concerned

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All those balking at the prospective changes to the Long-Term Capital Gains (LTCG) norms on Equity Mutual Funds need to ask themselves just why they're so concerned. Personally, I feel this will be a fantastic move.

Various theories are floating around, largely based upon conjecture; but it seems likely that the upcoming budget will bring about some form of change to the current rule that makes profits earned from equity mutual funds tax-free after a year. Debt funds don't quite have it so good, taxation-wise.

It's unlikely that LTCG from equity mutual funds will be taxed, but an extension of the present one-year holding period to three seems to be on the cards. What this effectively means is that you'll need to hold on to your units for a couple of years longer to enjoy the previous tax sop. This is actually pretty great, for more than one reason.

First, I've long argued that the key determinant of one's optimal asset allocation or tactical investment decisions cannot be tax efficiency or tax savings. And yet, as a nation replete with tax-saving-hungry investors, we ever so often wind up missing the woods for the trees by remaining averse to booking profits in one fund or asset class in a timely manner, in order to save the associated tax. For instance; clients who are sitting on 15% - 18% returns from their long-term debt funds in the past year may be making a wise move by booking short-term capital gains and moving into shorter term accrual funds sometime in this calendar year. And yet, goaded by the prospect of paying lesser taxes if they held on for two more years, few will.

Over the years, I've witnessed countless investment decisions go wrong because investors selected asset classes based on their tax efficiency, only to regret their decisions when markets went awry and their portfolios slipped into the red. The selection of instruments for one's investment portfolio should be made purely based on suitability, led primarily by ones risk tolerance. Narrowing the tax efficiency gap between equity and debt mutual funds will enable investors to think more clearly while planning their asset allocation, minus the dangling tax-savings carrot.

After all, why should one be penalised with a higher tax burden for being more risk-averse; or for that matter, be rewarded for being a risk taker? From a longer-term standpoint, it's far more important that investor funds are placed in a manner that actually permits them to hold on to them for an adequate amount of time. In other words, tax norms must play their role in enforcing, or at least encouraging, correct financial planning practices and investor behaviour.

Second, if you're investing into an equity mutual fund with a time horizon of one year, you're probably setting yourself up for much grief. The reduction in the short-term tax advantage on equity funds will actually serve the greater purpose of keeping at least a cross section of the 'punters' at bay. Those who are betting on market direction rather than investing based on fundamentals are better off making small bets using derivatives, with moneys they can afford to lose entirely. Mutual Funds comprise of stocks which may or may not unlock value within a year; by using them to wager on market direction, one achieves neither the thrill of short term profits, nor long term wealth creation.

The third benefit will accrue to the fund manager; and to investors indirectly. By reducing the quantum of hot money, as well as money flowing in from risk averse investors for the wrong reasons, this move could lead to a spike in the average holding periods for equity mutual funds. Faced with lower redemption pressure, fund managers may be able to take better long-term, value based stock picks. They will also need to maintain lower cash percentages in their portfolios to provision for redemptions. This is likely to generate some degree of outperformance, at least from the better managed funds.

Our country's current norms on capital gains tax are complicated. LTCG on Debt Funds arise after three years and are indexed. For listed bonds, the stipulated holding period is 12 months, post which LTCG applies. For Equity Funds, LTCG in NIL. A commensurate definition of 'long term' is definitely in order.

If the move were to come through, investors should welcome it. For genuine investors, it'll be a moot point. For short term investors, it'll serve as a small nudge in the direction of making them more "Buffet-esque".

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