Taxation

Tax Implications of Different Types of Investments

Management of tax as an investor is a supremely complex issue, and it is for this very reason that amateur investors are recommended for working with an experienced chartered accountant for the minimization of the impact of taxation on their investment gains. Many investors search for investment options, the likes of which are generally limited to pension schemes, insurance, and government-sponsored savings schemes. we discuss the Tax Implications of Different Types of Investments.

However, if the investor intends to make an investment in mutual funds, stocks, and other such financial instruments, it is best to understand the legal and tax implications of the same LTCG (Long-term capital gains) are equity delivery-based instruments with holding periods of longer than a year, while STCG (short-term capital gains) are those with holding periods of less than a year.  The present article shall discuss the tax implications of different types of investments to clarify the same, which can, in turn, facilitate better investment decisions.

Key Consideration while Choosing the Type of Investment

 The investor must consider the following factors before choosing the type of investment

• Return on Investment (ROI)

Return on investment is the benefit enjoyed by the investor subsequent to the deduction of the cost of the investment. It can be as dividends, interest, or capital appreciation (an increase in the asset’s value ). It should be expressed as the net after-tax income, which must be higher than the inflation rate. Usually, there is a direct link between risk and return on investment.

• Risk

From the perspective of finance, risk refers to the possibility of losing money due to unforeseen circumstances. The higher the potential return is, the higher the potential risk of losing money. For instance, making an investment in shares has a higher risk than investing in a fixed deposit, but it also promises higher returns.

• Investment Period / Investment Term

The investment period refers to the duration (length of time) of the investment, which can influence the return on investment. The investment can be short, medium or long-term. The holding period for Long-term investments must be more than a year, while the holding period for short-term investments is for one year or less. Long-term investments generally provide higher returns than short-term investments. The investment period depends on the personal needs of the investor.

• Liquidity

Cash is considered a liquid asset due to its easy accessibility and the most common mode of purchasing everything. Liquidity, therefore, refers to the degree of ease with regard to the conversion of an investment into cash. In case of emergencies, there should be an amount of capital allocated to an investment which can easily be converted to cash.

• Taxation / Tax Implications

Different investments have different tax rates. The investor must consider income tax implications for securing a high net after-tax return. A good investment must produce a good after-tax income.

• Inflation Rate

The inflation rate is a percentage computed annually for measuring the rise of the average price of goods and services in the economy. If the inflation rate increases, the purchasing power of consumers decreases. A good investment should have an ROI that is higher than the inflation rate. Some investments like property and shares are positively impacted by inflation. Their value can increase as inflation rises.

• Volatility / Fluctuations on Investment Markets

Volatility is a rise and fall of market prices. In the event of frequent swings or fluctuations in the market, it is seen as highly volatile. Low volatility implies that the investment, market or economy is stable. Before making an investment, the investor must consider the fluctuations in national and international economic trends. The level of volatility will impact the amount of returns that the investment yields. Market volatility is usually associated with investment risk.

• Investment Planning Factors

When planning investments, the investor must consider the safest possible investment opportunities. Although some investments offer low returns, they can be a safer option than those that offer higher gains. Explore opportunities having a history of good returns. For the minimization of risk, the investor must divide investments between the different investment options. The method of calculating interest should also be considered.

• Budget

Investors must budget for unexpected costs. The budget must provide for emergencies, savings and investments. Investors can decide the amount of surplus money for investments.

Tax Implications on Different Types of Investments

The tax implications on different types of investments are discussed below –

Tax Implications for Equity Shares

As per the Income Tax rules, Equity shares are capital assets; therefore, any profits from the sale of Equity shares attract Capital Gains Taxation rules. In India, investors can choose from unlisted domestic Equity shares, listed domestic Equity shares and Foreign Equity Shares. Each has a different tax treatment, as elaborated below –

• Listed Domestic Equity Shares

If the holding period of listed Equity shares is less than 12 months prior to their sale for a profit, the gains from the same shall fall under the Short-Term Capital Gains (STCG). Similarly, Capital Gains from Equity Shares with a holding period of more than 12 months shall come under   Long Term Capital Gains (LTCG).

STCG rate for listed domestic Equity Shares is 15%, whereas the LTCG tax rate is 10%. The 10% LTCG is computed post an exemption of up to Rs. 100000 on aggregate LTCG  in a financial year. (FY)

• Unlisted Domestic Equity Shares

For unlisted domestic Equity shares, LTCG tax rules shall be applicable if such shares are held for 24 months or more, whereas it shall attract the STCG tax rules if being held for a period less than 24 months.

For unlisted domestic Equity shares, STCG shall apply on the basis of the investor’s  Income Tax slab rate for the FY. The LTCG, in this case, is calculated as 20% of gains along with the benefit of indexation.

• Foreign Equity Shares

The investment limit in stocks listed on a foreign stock exchange for Indian residents is US$2.5 lakh in an FY. From the perspective of taxation, foreign Equity shares are taxed the same as unlisted Equity shares. So, Capital Gains from foreign Equity stocks, the holding period of which is 24 months, are taxed as STCG, whereas the LTCG tax rate applies if the holding period exceeds 24 months.

The STCG tax rate for foreign Equity shares is in accordance with the investor’s  Income Tax slab rate. Similarly, the LTCG tax rate, which applies to foreign Equity shares, is 20% with indexation.

Tax Implications for Mutual Funds

Mutual Funds’ investments can be made in various asset classes such as Debt, Equities or a combination of different asset classes. Depending upon the type of investment, Mutual Funds can be classified as Debt Mutual Funds, Equity Mutual Funds, or Hybrid Mutual Funds. Taxation rules of Mutual Funds can vary depending upon the underlying investments, which are listed below –

• Equity Mutual Funds

Equity Mutual Funds invest 65% or more of their investable assets in Equity-oriented assets like domestic Equity shares. From the taxation perspective, the treatment of Equity Mutual Funds is the same as domestic Equity shares.

So STCG at 15% is applicable to capital gains from Equity Mutual Fund units having a holding period of 12 months or less than that period. For a holding period exceeding 12 months, capital gains from Equity Mutual Funds are taxed as LTCG, wherein the LTCG rate is 10% of cumulative capital gains over Rs. 1 lakh for an FY.

• Debt Mutual Funds

Debt Mutual Funds are necessarily required to invest 65% or more of their assets in the Debt investments such as  T-bills, Certificates of Deposits, bonds etc. The tax rates and holding period for Debt Funds differ from Equity Mutual Funds.

For Debt Mutual Funds, capital gains from units with a holding period of 3 years or less attract Short Term Capital Gains. So LTCG in Debt Funds applies to units with a holding period than 3 years before being redeemed at a profit.

The STCG rate for Debt Funds is calculated in accordance with the applicable Income Tax slab rate of the investor. LTCG rate for Debt Funds is 20% with indexation. An earlier provision for opting for the LTCG at 10% without indexation is unavailable to any units sold after 10th July 2014.

• Hybrid Funds

Under the SEBI regulations¹, Hybrid Funds can invest in 2 or more asset classes such as Equity, Debt, Gold, etc. The taxation of Hybrid Funds is thus dependent upon the Equity-oriented investments comprising up to or more than 65% of the scheme’s portfolio.

A Hybrid Fund investing 65% or more of its assets in Equity-oriented investments has a tax treatment similar to Equity Mutual Fund. Similarly, in the event of the Equity-oriented investments being less than 65% of a Hybrid Fund’s assets, it is taxed like a Debt Mutual Fund.

However, some types of Hybrid Funds, such as Multi-Asset Allocation Funds and Dynamic Asset Allocation Funds, are a bit more dynamic. So there can be an extension of their Equity Allocation or be less than the 65% threshold from time to time, wherein the investors must use the asset allocation information in the latest monthly factsheet to ascertain the set of capital gains tax rules which shall apply in this case.

• International Funds

International Funds that primarily invest in Equity shares listed on foreign stock exchanges have gained popularity among investors in recent years. Even though these Mutual Funds invest in Equities, their tax treatment is like Debt Mutual Funds.

Therefore, International Fund units sold at a profit before the completion of a period of 3 years are taxed according to the  Investor’s Income Tax Slab rate. And, the fund units held more than 3 years prior to the redemption qualify for long-term capital gains equal to 20% with indexation.

Some Equity Funds in India, such as Parag Parikh Flexicap Fund, make investments in both domestic and international equities. For these funds, the applicable taxation rule shall be dependent on the proportion of the scheme’s assets invested in domestic Equities.

As per the present rules, if an Equity Mutual Fund has invested 65% or more of its assets in domestic Equity shares,  their tax treatment will be on the basis of the same rules as that of any other Equity Mutual Fund. However, if the fund has invested less than 65% of its assets in domestic Equity stocks, its treatment will be the same as a Debt Fund from a taxation perspective.

Tax Implications for Exchange-Traded Funds

Exchange Traded Funds or ETFs are similar to Mutual Funds due to them being investments. However, the difference is that they traded on stock exchanges like Equity shares. They are presently 4 types of ETFs in India – Index ETFs, Sectoral ETFs, Gold ETFs, and International ETFs.

Index ETFs track the movement of indices such as the SENSEX or the NIFTY, whereas sectoral ETFs track sector-specific indices such as the Bank Nifty. For the purpose of taxation Index and Sectoral ETFs are treated the same as Equity-oriented investments. Therefore if they are held for more than  12 months, LTCG tax at 10% applies on aggregate gains exceeding Rs. 1 lakh in an FY ., Whereas STCG tax at 15% applies for a holding period shorter than 12 months.

Gold ETFs and International ETFs have a similar tax treatment to that of Debt Mutual Funds. Hence if the same is held for less than 36 months, STCG tax is according to the investor’s income tax slab rate. If the holding period exceeds 36 months, LTCG tax at 20% with indexation shall be applicable.

Tax Implications for Fixed Income Investments

Fixed Income investments, like bonds, can be either listed or unlisted, thereby impacting the rules governing the taxation of the investment. Examples of listed Debt instruments are debentures, Government Securities, corporate bonds, tax-free bonds, etc.

For listed Debt instruments, LTCG is applicable if such instruments are held for a period of more than 12 months, whereas STCG is applicable if such period is less than 12 months. The STCG rate for these investments shall be as per the Tax slab rate of the investor. The LTCG tax rate is either 10% without indexation or 20% with indexation.

But, as per the present taxation rules, the indexation benefit applies only to a few listed Debt instruments, such as Sovereign Gold Bonds issued by the RBI and Capital-Indexed Bonds which are issued by the Government of India.

For unlisted bonds and debentures, the threshold holding period of 36 months is applicable for ascertaining short-term or long-term capital gains. In this case, the STCG tax rate shall be applicable in accordance with the Income Tax slab of the investor. The LTCG tax rate for unlisted Debt instruments is 20% without indexation.

Tax Implications of Gold Investments

Presently, there are multiple ways to invest in gold, even though traditionally, the physical form has been most popular, which can be in the form of jewellery, gold coins, and bars. Gold is also purchased as financial products such as digital gold, Gold ETFs, Gold Mutual Funds, and Sovereign Gold Bonds.

From the tax perspective, 4 of these Gold investments in India – physical gold, digital gold, gold ETFs and Gold Mutual Funds are considered the same. All of these investments qualify as LTCG upon being held for a time period of more than 36 months. The STCG tax rate for a holding period shorter than 36 months is as per the Income Tax slab rate of the investor. LTCG rate is 20% with indexation.

The tax rules differ in the case of  Sovereign Gold Bonds. In this case, all capital gains are tax-free when the bond matures. But, if an investor exits this investment before maturity, then the same STCG and LTCG tax rules are applicable to other types of gold investments.

Tax Implications for Real Estate Investments

Immovable property such as Real Estate attracts its own unique set of capital gains taxation rules. For these types of investments, STCG tax rules are applicable for a holding period shorter than 24 months, whereas LTCG rules are applicable if the holding period exceeds 24 months.

For real estate investments, the STCG tax rate shall depend upon the income tax slab rate of the investor. The LTCG tax rate applies at  20% with indexation on these investments. But, the sale and purchase of Real Estate also have some additional types of tax rules and conditions, such as 1% TDS on property sales that exceed  Rs. 50 lakh, mandatorily reporting sales which exceed Rs. 30 lahks to the IT Department, etc.

 Another  Real Estate investment that has become popular in India in recent yrs is Real Estate Investment Trusts or REITs. Presently, there are two key types of REITs available in India – Listed REITs and REITs Mutual Funds.

Investors have the option of purchasing listed REITs on the stock exchange, and having a Demat account is a mandate for such investment. Examples of listed REITs in India are Brookfield India, Mindspace Business Parks, and Embassy Office REITs. In the case of these REITs,  it is mandatory for them to be held for 36 months for qualifying for long-term capital gains. The STCG tax rate on REIT units held for less than 36 months is 15%. The LTCG tax rate for REIT investments is 10% on gains exceeding Rs. 1 lakh.

Investors can purchase REITs Mutual Funds such as International REITs fund of funds in the absence of a Demat account. These investments are taxed in accordance with the rules of Debt Mutual Funds. So STCG rate is according to the Income Tax Slab rate of the investor if they are held for 36 months. On the contrary, the LTCG tax rate for REITs Mutual Funds is 20% with indexation if the holding period exceeds 36 months.

Conclusion

Having clarity about the tax implications of different types of investments provides two key benefits. Firstly, it enables the anticipation of the actual profits from the investment ahead of time for the investor. Secondly, through making correct tax payments, the chances of being audited or receiving a notice from the Income Tax Department are significantly reduced, which can enable saving a great amount of investors’ time and effort f in the long term.

Read Our Article: Tax Implications of Selling a Property

1. https://www.sebi.gov.in/sebiweb/home/HomeAction.do?doListing=yes&sid=1&ssid=3&smid=0