This article settles the question of which type of capital gain calculation is better - debt-type funds taxed at 20% with indexation vs equity-type at 10%.
Disclaimer: Taxation is a dynamic concept and the content of this article is valid on the date of publication and any subsequent updates. Always consult a professional tax advisor before doing anything that leads to taxes being due.
Capital gains are the profit from selling a capital asset like stocks or mutual funds. Capital gains are of two types depending on the holding period (see table A below):
Long-term capital gain: LTCG
Short-term capital gain: STCG
While talking about the LTCG for mutual funds, an interesting problem arises (see table A below):
equity-type funds (>65% Indian equity) are taxed at 10% on profits beyond ₹1 lakh when sold after a year
debt-type funds (i.e all other funds) are taxed at 20% on profits with indexation benefit when sold after three years
We will examine over the long term (i.e. 3 years or more), which leads to lower taxation. While we might be tempted to say that the 10% case has a lower tax, the indexation benefit of debt-type funds might lead to a different result even with a 20% tax rate.
Should you invest in international stocks and funds if they are taxed at higher rates?
The question comes from the fact that, apart from debt funds, international funds also have the same debt-type taxation rules.
Table A: Taxation of stocks and mutual funds
Short-term capital gains | Taxation
Long-term capital gains | Taxation
Shares, Equity MF or equity-oriented Hybrid MF
>65% Indian equity
<365 days | 15% + cess + surcharge
>= 365 days | <1 lakh/year is tax free. Gains above 1 lakh are taxed at 10% + cess + surcharge
Debt or Hybrid funds (debt oriented) or International funds
<65% Indian equity
<3 years | Taxed at slab rate
>=3 years | 20% + cess + surcharge on gains post indexation
where, Capital gains = (Selling price - Buying price) * Units sold
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Which is better 10% tax or 20% after indexation
To understand the difference between the two taxation rates, we need to understand one fundamental point:
Indexation = Return - Inflation
If your asset grows at an average of 10% while inflation is 7%, then the taxable return is 3% per year.
debt-type calculation will be 20% on a 3%/year profit
If we run the numbers,
tax on equity-type will be 10% * [(1+0.1)^10-1] = 15.94%
tax on debt-type will be 20% * [(1+0.1)^10/1+0.07)^10-1] = 6.37%
On a ₹1 lakh investment, the maturity values will be:
₹2,43,437 under equity-type tax calculation
₹2,53,004 under debt-type tax calculation
the difference is ₹9,567
We will now show sensitivities for this result for a ten-year holding period:
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As the table shows, the gap at 7% inflation and 10% returns is ₹9,567 as calculated above.
How does this tax calculation matter in the long term?
We show a different type of sensitivity table for real returns (fund returns less CII) vs. the holding period. This is important since real returns over long-term holding periods are expected to be very close to zero.
(click to open in a new tab)
As the table unambiguously shows, for longer-term holding periods at a portfolio level, it is better to have a 20% tax with indexation as the tax rule.
Disclaimer: Content on this site is for educational purpose only and is not financial advice. Nothing on this site should be construed as an offer or recommendation to buy/sell any financial product or service. Please consult a registered investment advisor before making any investments.
This post titled Which mutual fund has lower tax - international funds at 20 percent vs domestic at 10 percent? first appeared on 21 Sep 2022 at https://arthgyaan.com