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Use the tax code to your advantage
May, 24th 2010

I would love to be a broker, if only for just a few months. And Id like to be in the job for a period of six months before and after the new draft direct tax code (DTC) is actually implemented (April 2011).

This is the time brokers are bound to laugh their way to the bank. Why, you might ask? Read on for the answer.

The devil is in the detail and more devils seem to emerge as the DTC is being read. This particular devil refers to the treatment of capital gains (CG) arising from the sale of shares and mutual fund units.

DTC proposes to tax CG at normal tax rates, thereby removing the benefit of a lower rate for capital gains on sale of shares held for over a year. It is also proposed that the securities transaction tax (STT) be abolished and the exemption or relief granted to long-term and short-term gains on the sale of shares be withdrawn.

Further, the date for substituting the cost with the fair market value for computing CG from April 1, 1981, has been advanced to April 1, 2000. Thus, appreciation in the value of assets between April 1, 1981, and April 1, 2000, will not be taxed. The concept of short-term and long-term capital assets has been done away with by the code. It proposes indexation benefits for all types of investment assets which are held for one year or more. So indexation benefit of current long term CG are retained and extended to all assets.

However, once DTC comes into force, the investors will need to prepare themselves for paying higher taxes on CG regardless of their income bracket. Is there a strategy to soften the blow?

Lets consider an example (see table). An investor had purchased 100 shares of Company A at Rs 10 in 2001. The market price of the share today is Rs 30 and we project this to be Rs 40 in March 2011 (an appreciation of 300% over two years). Also, assume that the investor falls in the income bracket of Rs 10-25 lakh. He thus needs to pay 20% of his total income as tax. The capital gains on the sale of each share will be Rs 30 (Rs 40-Rs 10). This translates into a total Rs 3,000.The effective tax payable will be Rs 600. (20% of 3,000)

The same would have been just subject to the STT under todays guidelines. So an investor will end up with an outflow of nearly Rs 595 due to the change in tax treatment.

There may be a way to save on this outflow. The investor can sell the shares that he holds for more than a year before March 31, 2011 and pay no tax on long-term CG. He can then buy back the same shares at the current market rates. The capital gains in 2011, in the above example, will be Rs 1,000 and tax payable will only be Rs 200. There will be an extra expense of STT and brokerage, which, however will be a mere 0.125% of the total consideration, at a conservative estimate. Hopefully, your broker is not charging you more than 1% in brokerage for each leg of the transaction.

As can be seen, the investor in effect saves Rs 258 or nearly 6.5% of the value of the transaction in 2011. This essentially implies a saving of Rs 6,500 per Rs 1 lakh of holdings. By no means is this a small amount. The amount of savings will be lower in case the investor is in the lower tax bracket and higher for investors in the higher tax bracket.

The other aspect to be taken into consideration is indexation. Indexation could increase the acquisition cost of the underlying assets, thus reducing the actual tax incidence. In the above example, figures in brackets refer to adjustments made for indexation. A few assumptions have been made with regard to the cost inflation index for 2010 and 2011.

The same will also be applicable to MF units. The possible savings will be higher in case of equity MFs as compared to other MF schemes, where long-term CG is at 10%. Therefore, it makes sense for investors to take a look at their portfolios and prepare to shuffle (sell and buy) all their longer-term holdings just prior to March 31, 2011.

The DTC, if applied in the manner proposed, would mean a windfall for brokers without any efforts on their part to earn the same, since investors will both sell the shares and then immediately buy them back. Now do you blame me for wanting to change my job for that brief period around March 2011?

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