From April 1 2011, all capital gains booked will be added to your income and taxed appropriately in your tax slabs. (Upto 1.6 lakhs – no tax, 1.6 to 10 lakhs – 10%, 10-25 lakhs – 20% and above that, 30%).

Then why is capital gains any different from other income? Answer: Long term gains are “indexed” – meaning, the government understands that when you sell an asset, you should consider inflation. If you bought something for Rs. 100 three years ago, and inflation was an average of 6% in the last three years, then the Rs. 100 is actually worth Rs. 118 today – three years of simple 6% inflation. (Note: the actual number will be slightly higher due to compounding effects). So if you were to sell that asset for Rs. 140 today, your gain isn’t Rs. 40 – it’s only Rs. 22; since you are only taxed on gains, it lowers your tax incidence by 50%!

For more details on indexing read: http://blog.investraction.com/2006/12/long-term-capital-gains-ltcg-applies.html.

The wider slabs, too, give you a lower tax payout. Yet, some of us have held stocks for a LONG time. Maybe 5 or more years. The gains are probably huge – some of them above 50%. If we sold them anytime after April 1, 2011, then we’d pay tax on the entire gain! This is of course unacceptable, given there is a cheaper way out.

You can sell all these shares today and buy them right back. Then, the gains will be assumed to be booked today – on which there is a capital gains tax of ZERO. That sorts the past gains. From here onwards, only the gains from the NEW purchase price to whenever-you-sell will count for taxation post April 1, 2011.

Example: In my family we own some shares of Hero Honda bought in the nineties. The effective cost price today, after all their bonuses, is about Rs. 12 per share. The share is at Rs. 1750+. Even if I indexed everything like crazy, my cost price won’t go beyond Rs. 100 per share – we have to pay taxes on about Rs. 1600 per share if we decide to sell after April 1, 2011!

The right thing to do then is to sell shares, get the money and buy them right back, because we want to be invested in Hero Honda. That takes care of the full gain till now – no tax on the 1600 rupees – and if Hero Honda goes to 2000 when we sell, we’ll only pay tax on Rs. 250.

And there’s another thing: if we sell now, before March 31, 2011 and buy shares back, we will get TWO years of indexation; indexing laws work such that each financial year of purchase is counted for indexing, which means a purchase tomorrow and a sale in April 2011 gives me two years of indexing – 2009-10 and 2010-11 – so I can get the advantage of two year’s inflation before my gains are counted.

To put it simply: If I sell now and buy back before March 31, I will save 12% of future gains as well. If Hero Honda went to 1960 and I sold it in April 2011, I will pay ZERO tax. Not bad at all, in a thirteen month scenario.

Another thing to think about: if you want to buy stocks for the long term, buy them before March 31. No matter when you sell them you get an additional year of inflation adjustment and saves you tax.

Downside notes:

• Selling and buying back involves payment of commissions and STT. That, for me adds up to less than 1% of the entire transaction value  (not just the gains). Considering the huge gains we have, we are better off than the potential tax of 10% on the whole deal. But to you it may be huge if the gains are not quite as much.  For example if you own 100 shares of Reliance at Rs. 800 for two years and it’s at 1000 today; your indexed gain if you sell now is just Rs. 100 per share, assuming 6% inflation. If you’re in the 20% bracket next year that would only result in a tax of Rs. 2,000. But a 1.5% transaction cost on selling and buying back 100 shares (@ Rs. 1000) today will cost you Rs. 3000. So do the calculations carefully before logging on to your broker’s web site.
• You need a two day break before you can buy again. The T+2 settlement system ensures that if you sell today you only get money after two working days. That means a “buy again” can only happen then. In the meantime the share could fluctuate in value, so there’s a risk.

The sell and buy back makes sense if you have very high gains and don’t want to pay tax on them.

This post is written by Deepak Shenoy, at Capital Mind.

HDFC Long Term Advantage Fund just announced a “37.5% dividend”.

The real yield is about 10%. (Rs. 3.75 on something that currently costs Rs. 36.545). Ignore the “37.5%” figure – it’s a remnant of an archaic system that has little or no value for anyone investing today.

We all know that dividends are your own money coming back to you. Technically you shouldn’t be bothered, whether you pay in and take it out as a dividend, or leave it in, it’s of no difference.

But with ELSS funds, there is a difference. The invested money is locked for 3 years, and you get a tax advantage on it. If you were offered a dividend, you could get a tax advantage on the entire amount, while still getting a part of it back as dividend! [The money would otherwise be locked for three years]

Example: You have Rs. 50,000 and you buy the above HDFC fund before Jan 11. You get a tax break on the entire 50,000 – worth Rs. 15,000 to you if you’re in the 30% bracket. And in a few days you’ll get back 10% of your money – or Rs. 5,000, as dividend. Effectively, you’ve saved yourself Rs. 15,000 in tax by investing only Rs. 45,000.

(A few years back, Birla Sun Life did a one-time stunt with it’s tax plan, giving back HALF your money. But they did it in a shady way – pre-announcing the dividend months earlier, which is not allowed by SEBI. Read this article for more details.)

Yields of 10% are not uncommon – and 10% is probably the lower end of the spectrum. Last year, HDFC’s other tax saving fund, HDFC Taxsaver, announced Rs. 5 dividend on an NAV of Rs. 34 – a 15% yield. If you’re looking to save tax but would like to not have to invest ALL the money, buy a tax saving fund that gives you a high yield, just after the dividend is announced.

Also read: Should you invest in tax saving mutual funds? and Mutual Fund Commissions on Tax Saving Schemes.

This post is written by Deepak Shenoy, at Capital Mind.

ELSS mutual funds are specially deductible under Section 80C, which applies to everybody. It really means you get a Rs. 100,000 deduction from income (i.e. taxes are calculated after this deduction) – if you spend or invest this 100,000 in some specific areas:

• Public or Employee Provident Fund contributions
• the New Pension Scheme contributions
• National Savings Certificates, 5 year Bank or PostOffice Deposits, NABARD Bonds
• Insurance premium (Premium < 20% of sum assured)
• Mutual Funds (ELSS)
• School fees for two children (includes Pre-school fees, yay!)
• Principal repayment on a housing loan (or full/down payment on a house)

They all come clubbed in the same 100,000 deduction – meaning if any combination of the above goes above 100,000 – then that’s all you get. First, find out if you’ve already exceeded the 100K deductible. If you have, don’t bother reading ahead.

Since you haven’t yet finished it all up, find out if you’re adequately insured. Hundred of insurance sites have them – for an IE only (no firefox) quick plan, check out this site. Then buy the plain term plan – Religare’s iTerm Plan, sold only online, is the cheapest by a LARGE margin. (I will pay Rs. 21K for a 25 year 1 crore policy, where the average other policy is 33K)

Do not buy ULIPs. They are evil.

If you still have anything left in that 100,000 tax deduction, you might think of ELSS mutual funds. Now you might be in for a surprise with the Direct Tax Code coming into force in 2011.

The DTC moves to an EET regime – Exempt on entry, Exempt on accumulation and Taxed at exit. ELSS is currently EEE – you save tax when you enter, and because of the STT benefit you pay no tax on exit. That will change – after 2011, any exit from an ELSS fund will be treated as “capital gains” and taxed in your tax bracket. If you buy an ELSS fund, the earliest you can exit is 2012-13, by which time the DTC will be active (and yes, it will apply to your old investments as well, unless they change the current draft)

The DTC even charges the withdrawal on the principal (not just the gain) – but it’s currently hazy about whether it will apply to past investments. Dhirendra Kumar at Value Research thinks that it will not apply to past investments and the draft code will be changed. Still, there’s a risk this works against you.

If you really need most of the money back in three years, buy a PPF/EPF instead – at least that has no tax on principal & interest till March 2011.

But the ELSS fund investment is a long term one and in all likelihood you can retain it for several years, only taking out what you might need. Even with tax, the gains from equity may be substantial, and high enough to outperform the PPF/EPF rates (the NPS has done 14 and 11% in the last two years; most ELSS schemes are just about where they were two years back)

With the higher mutual fund commissions too, their future returns are suspect. But I’d say this – it’s probably a better bet to go with a good tax saving fund and keep the money in there till you retire. It’s a good long term saving system with enough liquidity that you can take it out anytime after three years, but won’t because it’ll get taxed. And if you don’t need the money, then please use the NPS – the ultra low management fees juice up the returns substantially.

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This post is written by Deepak Shenoy, at Capital Mind.