Reading Between The Lines

Updated: Jul 25 2004, 05:55am hrs
Are you prepared to live with the new turnover tax regime Many of the retail investors may quip: do we have an option Indeed, investors hardly have an option, but to pay a tax on buying and selling of shares and equity funds. So, know your tax liability and change your investment behaviour if it serves your financial objectives.

Finance minister P Chidambaram exploded a bomb while making his budget speech in parliament on July 8. His mention of a tax (0.15 per cent) on trading in securities triggered panic off-loading in bonds and stocks. The markets gave a big thumbs down to the proposal on the budget day. On the following day, traders deserted the bond street as their trades in debt market were on wafer-thin margins.

While brokers and day traders/arbitrageurs were up in arms against the new tax regime forcing the finance minister to correct various anomalies, investors in the absence of a forum could not air their grievances.

Although the new tax regime offers a big incentive in the form of waiver of long-term capital tax, the turnover tax could pinch when somebody makes a loss or an insignificant gain on an investment. Its like, rubbing salt on the injury, quips one retail investor.

FE Investor takes you through the web of turnover tax (securities transaction tax) to understand its impact on equity as well as mutual fund investments.

Mutual Funds
The incidence of turnover tax on a mutual fund investor (read equity oriented fund) is very high as compared to investment in shares. Equity oriented-mutual fund investors have to shell out more to the government and hence, their cost of investment could also see a sharp rise.

Says Dhirendra Kumar, chief executive, Value Research, a firm that tracks mutual funds: To put it in a nutshell, status quo, more or less, prevails in bond funds. However, there will be additional cost for equity fund investors compared with investment in stocks. With the exemption of bond funds from transaction tax, debt oriented funds escaped the death trap.

The cost to an equity fund investor would increase as he may have to incur additional cost in the form of turnover tax when he makes a buy and sell transaction. Also, the fund which would pay turnover tax on its transactions would pass it on to the investor, says KK Mital, senior vice-president and head, Escorts Mutual Fund.

While the finance minister announced in Parliament that the proposed turnover tax (15 basis points) would be equally split between the buyer and seller, there is still some ambiguity regarding its application. Will the mutual fund be classified as a seller of open-end equity funds

If funds are classified as sellers, they have to share half the tax liability (7.5 paise). Mutual funds, however, in all likelyhood may not bear this additional cost as they can charge it on the net asset value (NAV) of an equity fund and its NAV gets reduced to that extent.

Hence, the actual tax incidence on an equity fund investor could be 15 paise for every rupee invested and 15 paise more when he redeems the units. While traders can claim credit for transaction tax against business income tax, a mutual fund investor does not get such protection from double taxation.

Equity-oriented Funds
An equity fund investor usually pays an entry load of between 1.75 - 2.25 per cent of his investment. In addition, there is an AMC fee which could be upto 2.25 per cent which is charged to the NAV. There are also other cost heads like brokerage, demat charges, etc, which are charged to the NAV. Depending on the operational efficiency of the fund house, these costs may vary between fund houses and reduce returns to that extent.

The transaction tax could further burden the unit holder. For instance, a back-of-the-book calculation reveals that if an equity fund churns its portfolio 10 times in a year, the turnover tax liability could be around 1.5 per cent of prevailing NAV. Hence, from entry to exit level, the additional cost to an investor due to turnover tax in this fund could be as high as 1.8 per cent (including 0.3 per cent as cess), reducing returns for the investor.

The investor is taking a hit as the tax liability is on his corpus and not on gains made from the investment. If the fund is not performing and the investor is forced to redeem units at a loss, still he will be paying a tax. His losses could mount due to reasons beyond market behaviour and fund management skills, as a result of the tax incidence.

So, investors could take a bigger hit in funds which churn portfolios regularly. The turnover tax will make a strong impact on fund behaviour. The funds which churn portfolio quite often could take a bigger hit. This also means fund managers cannot afford to take too short-term a view, says Mr Kumar.

The cost of investment further rises in growth schemes if the unit holder books profit in the short-term which attracts capital tax at the rate of 10 per cent. It goes without saying that an investor would gain only if the return generated by the fund is substantial enough to offset the additional tax liability.

Bond Funds
There wont be any additional cost to retail investors. However, investors would have to bear dividend distribution (at the mutual fund end) at the rate of 12.5 per cent, short-term capital gains (30 per cent for the highest tax bracket) and long-term capital tax (10 per cent).

Equity Investment
Small investors believe that the rollback is biased towards the brokers. Market analysts, however, say that in the long run, investors will stand to gain.

Another benefit in the revised proposal is that the retail investors need not pay the whole 0.15 per cent while buying of shares. Only half, or 0.075 per cent, would be charged on purchase and the other half can be postponed to the time when he actually sells his holdings.

Lets illustrate the gain or loss suffered by retail investors in the new regime as against the older capital gains tax regime (see table).

If an investor buys shares worth Rs 10,000 and is able to make a 10 per cent profit over the long term, he would be gaining under the new system as against the old.

His total gain under the new system would be Rs 806 or 8.1 per cent as against Rs 739 or 7.4 per cent under the old system of long term capital gains tax of 10 per cent.

In case he decides to sell his holdings within one year, he would pay a 10 per cent short term capital gains tax and his actual gains would be Rs 725 or 7.3 per cent as against Rs 575 or 5.8 per cent under the old system of 30 per cent tax.

However, the situation would be different in case the investor is in losses. If he books a loss of 10 per cent in long or short term, he would stand to lose more under the new system as he would still have to pay transaction tax and his actual loss would be Rs 1,176 or 11.8 per cent. This would be higher than Rs 1,162 or 11.6 per cent under the old system where he would not paid any tax.

Reduction in the tax rate on day trading may also benefit the retail investors in the form of liquidity as volumes in the market may not fall. It was feared that the continuation of 0.15 per cent tax on day-trading would have severely impacted the trading volumes thus reducing liquidity in stocks.