Assessing Tax impact while choosing investments

Assessing Tax impact while choosing investment vehicles

My client, a media professional, had a desire to own his own stocks and when he received an inheritance , he immediately opened an account a  Portfolio Management Scheme . As luck had it , markets rallied and the PMS delivered spectacular returns . All was well till it was time to file the year’s  ITR. His annual taxable income was 48 lakhs and a long term capital gains of 6  lakhs had been booked in the month of Dec 2022 . At a 10 % long term capital gain tax , with  one lakh exemption , my client was happy that the extra  tax liability was only Rs.50,000 . To his surprise his CA asked him to deposit 1.77 lakhs extra in taxes . How did the tax amount jump up from Rs.50,000 to 2.23 lakhs ?. The tax payable was more than four times the amount anticipated by my client. The culprit was  the capital gain that took his total income above 50 lakhs , a slab that attracts a 10 % surcharge on total taxes. Look at the table below to see  impact of unplanned capital gains on  total taxes

	Income at 48 lakhs				Income at 1.95 cr
	Normal rate	Post Additional  Capital Gain			Normal rate	Post Additional  Capital Gain
Capital gain		600000				600000
Income from profession	4800000	4800000			19500000	19500000
Tax on Capital Gain		50000				50000
Tax on Income from Profession	1522500	1522500			5932500	5932500
Total Taxes	1522500	1572500			5932500	5982500
Applicable Surcharge	%	25%			15%	25%
Post surcharge Tax payable	1522500	1965625			6822375	7478125
education cess	4%	4%			4%	4%
Total Tax payable	1583400	2044250			7095270	7777250
Difference in tax		460850				681980

My client ended up paying 4.6 lakhs  in taxes , thereby wiping away a large part of  the capital gains made.If he fell in the higher income brackets , this impact could be much higher. Look at the above table- if he had income of 1.95 cr, a capital gain  of six lakhs could impact his total taxes by 6.8 lakhs ( wiping out the entire capital gain made ).

The point of this story is that your tax situation is a vital criteria in selection of investment product . While HNIs 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 the capital gains is inevitable , but like in my clients 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 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 many  times capital 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 Cat III AIFS with the same themes as the PMS. CAT III AIFs pay tax at  the fund level. The gains on exiting an AIF don’t get taxed investors hands ( as the fund has already paid taxes on your behalf). Also you don’t have to account for the capital gains and dividends in your books. This is a huge relief from the book keeping point of view  as well. An important point to remember is that CAT 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 AIFs offer .

To sum up , you have to measure impact of taxes into 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.