HOW TO ASSESS YOUR TAX IMPACT WHILE CHOOSING INVESTMENT VEHICLES
Impact of taxes has to be calculated on overall income and not just at a product level
My client, a media professional, had a desire to own certain stocks and when he received an inheritance, he immediately opened an account in a Portfolio Management Scheme (PMS). As luck would have it , the markets rallied and the PMS delivered spectacular returns. All was well till it was time to file the year’s income tax return (ITR). His annual taxable income was ₹48 lakh and long-term capital gains of ₹6 lakh had been booked in December 2022. At a 10 % long-term capital gain tax, with ₹1 lakh exemption, my client was happy that the extra tax liability was only ₹50,000. To his surprise, his chartered accountant asked him to deposit ₹1.65 lakh extra in taxes. The tax payable was more than four times the amount anticipated by my client, from ₹50,000 to ₹2.15lakh. The culprit was the capital gain that took his total income above ₹50 lakh, a slab that attracts a 10% surcharge on total taxes (see graphic).
My client ended up paying ₹2.15 lakh in taxes, thereby wiping away part of the capital gains made. If he fell in the higher income bracket, this impact could be much higher. For example, if he had an income of ₹1.95 crore, a capital gain of ₹ 6lakh could impact his total taxes by ₹6.8 lakh ( wiping out the entire capital gain made).
Your tax situation is a vital criterion in the selection of investment products. While HNIs (high net worth individuals) flock to PMS due to customized portfolio construction, the benefits of such unique portfolios have to be evaluated against the costs associated with them. Taxation on capital gains is inevitable, but like in my client’s case, it can have an adverse impact on overall tax outgo. If you have made a one-time large professional or business income, or if you have had a property sale or any similar large income in a year or if you belong to the higher income slabs, the impact of unplanned capital gains can be severe. Not only are you impacted by higher surcharges, but also higher penalties as capi
tal gains from PMS are reported late and cause a problem in advance tax payments of HNI clients.
To overcome the tax issue with PMS, many large fund managers have created Category III alternative investment funds (AIFs) with the same themes as the PMS. Such AIFs pay tax at the fund level. The gains on exiting an AIF don’t get taxed in investors’ hands ( as the fund has already paid these taxes). Also, you don’t have to account for the capital gains and dividends in your books. This is a huge relief from the bookkeeping point of view as well. An important point to remember is that category III AIFs pay a 15% surcharge on capital gains and 37% surcharge on dividends and other income irrespective of your actual tax slab. In the case of mutual funds, sale action within the fund attracts no tax, thereby making it the most tax-efficient. However, you may not find the unique portfolio strategies that PMS and AIF offer.
To sum up, you have to measure the impact of taxes on your returns before choosing the right vehicle for equity investments. Such impact has to be calculated on overall income and not just at a product level.
Kavitha Menon is a registered investment adviser and founder of Probitus Wealth.