Save Smart. Is tax-harvesting that good an idea?

With the equity markets soaring to new highs, a new term is hogging limelight-- tax harvesting. This is particularly for investors in equity mutual funds.

For the uninitiated, this refers to the attempts of equity mutual fund investors to harvest the exemption on long-term gains (up to ₹1 lakh), every financial year on their investments. This is done by selling their long-term equity investments till their aggregate gains total to ₹ 1 lakh (in a year), and subsequently repurchasing the investments at the same price (or NAV). Since the sale price now becomes your cost of acquisition, you can repeat this set of sale and repurchase transactions again after a year (when these equity investments qualify for long- term capital gains). Doing this year after year lowers your overall tax liability, to an extent, when you finally sell the equity fund investments.

But the game is not worth the candle, considering that the savings every year are only limited to ₹10,000 (long-term capital gain at 10 per cent on ₹1 lakh). Besides, this seemingly good idea has many practical hurdles. Let’s discuss some of them.

General caveats

Before discussing the technical hurdles faced, one must understand the rules of taxation clearly. The exemption of up to ₹1 lakh on long-term capital gains (LTCG) is only applicable on the aggregate LTCG on equity investments — listed stocks and/or equity-oriented mutual funds — in a financial year. The gains shall be taxed as long term only when such equity investments are held for more than 12 months. Besides, the Income Tax Act defines equity-oriented mutual funds as only those where at least 65 per cent of the fund’s proceeds are invested in equity shares of listed domestic companies. If it is a fund of funds (FoF), the underlying fund should invest at least 90 per cent of total proceeds in listed domestic companies for FoF to be classified as equity-oriented funds.

This clearly excludes funds that invest predominantly in international equities, debt securities and unlisted Indian equities etc. for whom rules of taxation differ.

Besides if you have made your investments through Systematic Investment Plans (SIP), then the cost of acquisition will be based on the units purchased initially-- First-In First-Out method. Also, remember that 12 months should have lapsed since the purchase date of each instalment of the SIP for the capital gains to be taxed as long term. Else, you will have to end up paying tax at the rate of 15 per cent on your short term capital gains.

Penny-wise and pound-foolish

Tax-harvesting differs from plain profit-booking, in that the investor continues to stay invested in the fund in the former. To be able to stay invested, you would have to repurchase your equity mutual funds, preferably at the same NAV, so as to avoid any losses due to the difference in daily NAVs. For this, investors need to be mindful of many factors.

One, the investor should be mindful of the cut-off timings for the transactions. The cut-off timing for equity schemes is stipulated at 3 pm -- certain third party websites/apps and brokers can have a cut off time earlier than the one stipulated by fund houses. That is, subject to availability of funds, if both the transactions are executed within the cut-off time, the same day’s NAV shall apply for the sale and repurchase transaction. Any delay in fund transfer (to the AMC’s account) or other technical glitch can subject the investors to the volatility in the equity markets – that is a difference in NAV in the sale and repurchase transaction. Your purchase transaction can also get delayed due to the time lag between debit of funds from your bank account and credit to the AMC’s account-- mostly prevalent in the case of transactions done using NACH mandate, NEFT and RTGS. The resultant change in NAV can disrupt your investments made for long term goals.

Two, since sale proceeds are not immediately credited to your account, you should be maintaining a fat balance in your bank account to be able to purchase the units at the same NAV. While SEBI stipulates a maximum of 10 days to credit the sale proceeds to your accounts, fund houses generally take up to three days. However, funds for the repurchase transaction must be credited to the fund house, before 3 pm on the same day, to avail the same NAV.

Three, do note that a few funds have ceased accepting lump sum purchases. For example, in September 2020, following the over-valuation in the small- cap space, SBI’s small cap fund, closed itself to lump sum investments after September 7, 2020. Further, on its SIP investments too the fund has a cap of up to ₹5,000 per month (per investor).

Four, be mindful of other incidental charges such as brokerage charges (applicable in the case of Exchange Traded Funds) on multiple transactions.

Five, the concept of tax harvesting assumes a market situation wherein gains on long-term equity funds are spread evenly over the years. But the equity markets do not always exhibit a linear growth. For instance, while the Sensex inched up by 11 and 17 per cent in FY18 and FY19, respectively, it crashed by 23 per cent in FY20. Thereafter in FY21 (thus far), the index rallied by 71 per cent. This volatility can end up distorting your tax harvesting plans.

Net-net, the process is too tedious for a maximum saving of ₹10,000 at the end of every financial year. Investors need to see if these marginal savings are worth the pain.

COMMENT NOW