No one quite likes the ‘T’ word but let’s face it – there is indeed nothing certain in life apart from death and taxes. And what’s also certain this year is the fact that we need to get used to paying tax on our equity investments.
So here’s a quick run through on what this tax will mean for your listed and unlisted equity holdings.
Onset of the LTCG Tax Era
FY19 will be remembered as the year that saw the re-entry of an old ‘villain’ in the
aam aadmi’s investment story.
Reintroduced after a gap of 14 years, the Long Term Capital Gains Tax (LTCG) will apply to all gains arising from equity investments from April 1, 2018. This includes shares, employee stock ownership plans (ESOP) and mutual funds.
The calculation of tax for listed securities is relatively simple. Gains made up to January 31, 2018 have been grand fathered, that is fully protected.
There after you need to consider the higher of the two – the original price at which the share/MF unit was purchased and the market price on January 31 to calculate your tax liability.
For instance, assume you bought stock A for Rs 100. Its price on January 31 was Rs 150. And its price at the time of sale (Any time after April 1, 2018) is say Rs 180. The capital gain on this transaction is Rs 180-150 i.e. Rs 30. The tax payable at the rate of 10% is Rs 3.
While the Union Finance Minister hasn’t offered any additional indexation cushion (a way of accounting for inflation while determining the fair market value of the asset), the good news is that gains up to Rs 1 lakh in a year are exempt from LTCG tax.
What that means is that you will have to get a little smart about your equity portfolio and make sure that you utilise this tax exemption limit by booking the gains and then reinvesting the money in the same stock or fund.
Reducing the LTCG tax hit
Let’s take an example of a monthly SIP of Rs 5,000. Assuming a 12% rate of return, this SIP will build you a corpus of Rs 12,76,000 over a period of 10 years on a total investment of Rs 6 lakh. If you choose to withdraw the money after 10 years, the capital gain is Rs 6,76,000 and the LTCG tax payable @ 10% will be a substantial Rs 67,600.
Now consider a scenario in which the investor books profit in the year in which the capital gain amount crosses Rs 1 lakh and reinvests the money. Since he has taken the advantage of the annual Rs 1 lakh LTCG exemption, the total tax liability at the end of 10 years comes down to just about Rs 17,700.
Now that’s a significant tax pay out difference worth considering.
So far so good because up till now we are dealing with listed equity shares. The real pain of the LTCG tax will actually be felt by those holding unlisted equity shares or stock options.
The LTCG hit on unlisted shares: IPOs & ESOPs
The grandfathering benefit of LTCG is available only to shares that were listed on January 31, 2018. Unlisted shares don’t get the same “step up” in value while calculating tax liability.
This means that if you are an investor in an unlisted company or an employee holding stock options in an unlisted firm, all the past gains made on your shares till January 31 will not be tax free.
Here, the law allows only a part of the old gains to be protected as per the cost inflation index. Here’s an example to explain how this works
Calculating LTCG tax on ESOPs issued by unlisted companies
Imagine you were allotted an ESOP at a price of Rs 100 in April 2015. The company you work for went public after January 31, 2015 and you then decided to sell your ESOPs in May 2018 at the prevailing market price.
Let’s assume this selling price is Rs 150. Now to calculate the tax liability you need to know what is the inflation indexed fair market value of this ESOP as of January 31, 2018. This is calculated through a simple formula:
Cost inflation indexed price = Allotment price of ESOP X (Cost inflation index of FY 2017-18 / Cost inflation index of the year in which you were allotted the ESOP)
The cost inflation index is set by the Income Tax Department every year. It allows us to adjust the value of an asset or a security taking inflation into account.
The value of the index for FY2017-18 is 272 and the value for FY2015-16 is 254. Thus in the above example, the cost inflation indexed price of your ESOP as of January 31 = Rs 100 X (272/254) = Rs 107.
Now, the capital gain on your ESOP is simply going to be the difference between this inflation indexed price and your selling price i.e. 150-107 = 43. The LTCG tax payable @ 10% will be Rs 4.3.
The cost inflation method of calculating is applicable not just to ESOPs of unlisted companies but also to shares being sold in an IPO by existing investors.
Which means only a part of the gains made by early stage investors will be protected when they exit their investment via the company’s IPO.So the tax is here and as of now it is staying. But let’s not end on a subdued note. As veteran equity investors always say, remember the power of the asset class you are in that power can easily make up for the small tax pinch. Just make sure you back the right growth stories and make informed equity investment choices!