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Making the Most of India's Tax Friendly Capital Markets
June 22, 2017

Almost 11% of an Indian household's savings are in financial assets. Of this, less than 1% is invested in capital markets. With a growing economy and tax measures that encourage capital market participation, can Indian investors afford to ignore capital market products in meeting their goals?

Author : iFAST Content Team



Indian households have one of the lowest rates of capital market participation in the world. Of the almost 11% of their savings that are in financial assets (including currency, bank deposits, insurance policies, provident funds, etc.), less than 1% is invested in shares, bonds, mutual funds, etc. While a large part of this may be attributed to our traditionally risk averse nature, there are also indications that we do not really evaluate our options correctly. Most investor goals stretch over a 5-15 year horizon, and capital markets usually generate the best returns over such a span, with reduced risk of volatility.

What do we mean by that?

The return generated by an investment is affected by inflation and taxes, and the actual return earned is usually lesser than we estimate. Investors thus need to consider returns after adjusting for current inflation rate and the tax payable. In both these aspects, Indian capital market products have the advantage over other products.

Bank deposits, the first choice of investment for many families, can illustrate this point perfectly. A few years ago, around 2012-2014, bank deposit rates were in the range of 8.5-9.5%, while inflation was at 9.76%. We have seen that investors preferred deposits at this time even though they were actually losing money (because inflation was higher than the deposit rates). Now, when bank deposit rates are around 6.5-7%, and returns on deposits are higher than the 3% inflation, investors are making very low inflation-adjusted returns of around 3.5-4%. Add to that the fact that the interest earned on these deposits attracts income tax as per the investor's slab rate, and the actual rate of return reduces even further.

In comparison, the Bombay Stock Exchange (BSE) Sensex returned 16.49% over the last one year, or 85.23% over the last 5 years. And considering that all returns on equity investments held for over one year are tax free, you can see why experts believe capital markets are the most efficient investment avenue.

Info Shots
  • Almost 11% of an Indian household's savings are in financial assets. Of this, less than 1% is invested in capital markets.

  • With a growing economy and tax measures that encourage capital market participation, Indian investors cannot afford to ignore capital market products in meeting their medium to long term goals.

  • Equity investments have the most favorable tax laws. With a long term horizon that reduces impact of volatility, equities can thus offer the most efficient means of capital appreciation.

  • Did you say tax free?

    All financial assets are taxed differently, making a real difference in the returns we get from them. Because Indians have been fairly shy of investing in the capital markets, the government tries to encourage this through favorable tax laws on capital market products. The government also distinguishes between gains made from short term investments and long term investments to discourage speculation and encourage investors to take a longer term view when investing in the capital markets. This has two benefits for the investor: longer term investments are safer as the impact of short term changes in prices evens out over time, and, the aggregate returns over the longer term tend to be better in a growing economy like India.

    Let's take a look at the tax rates for the most common capital market products:

  • Equity: All equity purchase transaction are charged a Securities Transaction Tax (STT) at the rate of 0.01%. If the shares are sold within a year of being purchased, a short term capital gains tax of 15% is payable. Capital gains on shares sold after more than a year are tax free. Capital gains on equity mutual funds (where a majority of the portfolio holdings are in equity) are also taxed in the same manner. Also, dividend income from equity mutual funds is tax free, and these funds are not charged any dividend distribution tax.
  • Debt: Capital gains on sale of debt instruments within three years of purchase are considered as short term gains, and are added to investor's income and taxed as per the slab rate. Long term capital gains are taxed at 10% without adjusting cost for inflation (indexation), or 20% after indexation. Capital gains made on all non-equity mutual funds are treated the same way. Debt based mutual funds also have to pay a dividend distribution tax of around 25% before paying dividend to investors.
  • Gold ETFs: Gold Exchange Traded Funds (ETFs) are taxed the same as debt securities - short term gains are taxed as per investor's tax slab, while long term gains are taxed at 10% without indexation or 20% after indexation.
  • Conclusion

    As we can see, taxation can make a significant difference to the actual return an investor collects. While risk assessment is crucial when selecting an investment product, an understanding of the tax treatment of gains can help investors avoid disappointment at the time of goal realization.

     

    iFAST Content Team is part of iFAST Financial India Pvt. Ltd.


    Disclaimer: iFAST and/or its content and research team's licensed representatives may own or have positions in the mutual funds of any of the Asset Management Company mentioned or referred to in the article, and may from time to time add or dispose of, or be materially interested in any such. This article is not to be construed as an offer or solicitation for the subscription, purchase or sale of any mutual fund. No investment decision should be taken without first viewing a mutual fund's scheme information document including statement of additional information. Any advice herein is made on a general basis and does not take into account the specific investment objectives of the specific person or group of persons. Investors should seek for professional investment, tax, and legal advice before making an investment or any other decision. Past performance and any forecast is not necessarily indicative of the future or likely performance of the mutual fund. The value of mutual funds and the income from them may fall as well as rise. Opinions expressed herein are subject to change without notice. Please read our disclaimer on the website.Please read our disclaimer in the website.


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