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How to earn tax-free income

A N Shanbhag | October 04, 2004 11:46 IST

Investors should reshuffle their portfolios soon after the Finance Act comes into force each year. Fortunately, FA04 has made it possible for a financially savvy individual to arrange his affairs in such a fashion that he can earn tax-free (= after-tax) income without any limit. Understandably, of course, the quantum of income will depend upon the size of capital and the rate of returns.

Debt-based MF schemes have outlived their utility

Soon after the concept of capital gains indexation was introduced by FA92, I discovered a strategy which allowed investors to not pay any tax -- legally.

It took advantage of the returns on pure-growth open-ended, debt-based mutual fund schemes. Debt schemes have now outlived their utility but it is still possible to have a tax-free income from your investments.  But first let us first examine the reason why debt-based schemes have outlived their utility.

Mark to market

This is a phenomenon, which supports investors in the falling interest rate scenario for debt-instruments. Interest rates and prices of fixed income instruments have an inverse relationship.

When the overall interest rates in the economy rise, the prices of fixed income earning instruments fall and vice versa. Adjusting the portfolio to the market rate of returns is called mark to market.

To illustrate, we assume that the current NAV of the MF is Rs 10 and its corpus is Rs 1,000 crore (Rs 10 billion) This means that if the fund sells all the assets of the scheme and distributes the money on an equitable basis to all the unit holders, they will receive Rs 10 per unit.

Now suppose, the interest rate falls from 6 per cent to 5.4 per cent. Immediately thereafter you wish to invest Rs 100,000 in the scheme. Realise that the entire corpus of the fund stands invested at an average return of 6 per cent.

If the fund sells the units to you at its current NAV of Rs 10, you will be allotted 10,000 units. This will benefit you immensely. You will be a partner in sharing the benefit of the higher returns of 6 per cent, though the fund will be forced to invest your Rs 100,000 at the lower rate of 5.4 per cent.

This is an injustice to the existing investors. Therefore, something has got to be done by the fund to protect their interest.

Here comes the 'mark to market' concept. The fund raises its NAV to Rs 11.11. You will be allotted only 9,000 units and not 10,000. The returns on 9,000 units at 6.0 per cent would be identical to the returns on 10,000 units at 5.4 per cent.

Therefore, the NAV rises when interest falls and vice versa. At this juncture, thanks to rising inflation, the pressure on interest rates in the upward direction is quite high.

Moreover, by now, many of the high-yielding debt instruments in a typical MF portfolio would be nearing their maturity or would have already matured. Therefore, it is time to bid good-bye to debt-based MF schemes.

An alternative parking place

Therefore, in the MF arena, one has to start considering equity-based schemes. These make good investments because:

  • Freedom from tax on dividends in the hands of the investor.
  • No dividend distribution tax required to be paid by the MFs.
  • Freedom from long-term capital gains tax.
  • Short-term capital gains taxed at the concessional rate of 10 per cent.

The one and only disadvantage is the risk factor. The fortunes of equity-based schemes are linked closely with the market and its associated volatility.

However, investing in a well performing diversified equity scheme somewhat mitigates this risk. Moreover, at this particular juncture, economic factors, especially the more than satisfactory monsoon, are very much indicative of robust market growth. In short, there can never be a better  time to invest.

The strategy

Now, consider a diversified equity-based scheme of a good MF. The dividends are truly tax-free. These do not even suffer the normal dividend distribution tax of 12.5 per cent.

Whether you opt for the  regular dividend option or  the growth option, the long-term capital gains are tax-free. What about short-term capital gains? In theory, these are taxed at 10 per cent. In practice, these are also tax-free. Surprised? Take a look at the table.

Suppose you have bought Rs 2 crore (Rs 20 million) worth of units of an equity-based scheme when its NAV was Rs 10. You have 20 lakh (2 million) units with you. In less than one year you find that you require Rs 10 lakh (Rs 1 million) very urgently.

Thankfully, MF schemes have no lock-in. Your request for repurchase of either part or all the units held would be catered for within less than 5 working days. This will entail payment of tax on short-term capital gains.

Let us compute this tax liability. You find that there is a modest appreciation of 5 per cent, which has taken the NAV to Rs 10.50. Your capital has appreciated by Rs 10 lakh. You repurchase 95,238 units, which have a value of exactly Rs 10,00,000 (= 95238 x 10.50).

The cost of acquisition of these units is Rs 9,52,380 (= 95238 x 10). Therefore, the short-term capital gain is Rs 47,620 (= 1000000 - 9,52,380).

Such gains are charged to tax at a flat rate of 10 per cent. You cannot avail of any tax deduction u/s 80L, 80D etc., or the tax rebate u/s 88 in respect of such gains.

However, the most beneficial part is -- "where the liability to tax arises in the case of an individual or an HUF only because of the inclusion of short or long term capital gains in the total income, tax will be levied at the capital gain tax rate on the excess over the minimum taxable limit."

Therefore, the income of Rs 47,620 being lower than the tax threshold of Rs 50,000, there is no tax liability.

To elucidate the benefit of the threshold, let us take another example. You have Rs 20,000 normal income, after claiming the deductions u/s 80L, 80D, 80G etc., and have earned capital gains of Rs 75,000. You will be required to pay tax only on Rs 45,000 (20000 + 75,000 - 50,000).

FA04 has inserted a new Section 88D with effect from FY 04-05. It offers a rebate of the entire amount of income tax payable, by a resident individual having total income (after deduction u/s 80L etc.) not exceeding Rs 100,000.

You will find that you can withdraw as much as Rs 21 lakh (= (100000 / 47,620) x 10 lakh) without having to pay a single paisa by way of short-term gains tax.

Unfortunately, this spectacular advantage is reserved only for residents and not for NRIs.

To sum

Since dividends are tax-exempt, even if paid within one year, it is better to opt for dividend-paying equity-based MF schemes.

Yes, there is the usual risk associated with equities, but it is a risk worth taking.

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Sub: How to earn tax-free income

The article assumes that the person using the strategy proposed by the author will have zero net income without including the short-term capital gain. This ...


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