“The Hardest thing to understand in the world is The Income Tax” – Albert Einstein
Assuming it was so difficult for him, one can think of its misery for common men.
From the desk of a practicing Chartered Accountant:-
Being a CA, the most common question asked to me almost every day and by everybody is “How to minimize tax”. Everyone feels burdened up with heavy taxation on their incomes especially the direct taxes where the direct benefit of that payment is almost invisible to us.
I believe you share the same view as well and must be looking for an easy answer to it. But, then the word ‘easy’ is a bit relative to everyone’s knowledge. So let’s discuss and I would try to make it’s understanding a bit easier for you.
Tax Avoidance: still a possibility?
See with the growing economy, the disposable income is also increasing in everyone’s hand. So, is increasing the number of people who evade taxes. The government in the last decade has made many changes to the Income Tax Act and tried to shut the door of possible misuse of law by such people. The world is moving towards e-governance and the income tax department is making the best possible use of technology. Why I am telling all this, this is to re-emphasize that any thought of evading tax may bring much heavier penal consequences and increased chances of being caught.
Tax Minimization: understanding the tax laws better in our favor!
Wait, tax minimization doesn’t mean only tax evasion. So, what could be the other way, should one reduce his income itself to reduce the tax burden. This idea will also be definitely disliked by all of you. There can be various other alternatives on which one can do tax planning viz. tax-friendly salary structure, selection of right kind of business structure, family income and estate planning, residential status, availing various deductions and exemptions under income tax and so on. There is no list to it and the solution may differ from person to person, case to case. What I have come across, while suggesting such measures, in most of the cases, the taxpayer doesn’t have much control over such areas to take advantage of these things due to one reason or other. Basically, we keep suggesting one or other options to minimize the tax burden on active income and grossly miss the tax planning on passive income generated by investments made.
How the tax impact coupled with inflation kills the real return on investments?
So, I would try highlighting this area today from my experience. When it comes to investments, products like Bank FD, Post Office FD, KVP’s, PPF, insurance, shares, mutual funds strikes us. An average citizen would generally compare their respective interest rates and take an instant decision based on it without thinking too much about the possible tax impact. It is important to note, on an average most of the fixed income products will deliver about 8%-9% return per annum. Barring, a tax deduction of Rs 50,000 to senior citizens on interest income and PPF interest, interest earned from most of the products is fully taxable. Assuming tax slab of 30%, the effective earned income is 5.5-6% per annum. On an average the inflation is about 5%, and it always has a higher impact on the middle-income group. So, by taking a wholesome view, the returns of fixed income products get nullified by inflation in any economy.
Does the taxation differ on other investment products?
Yes, if you treat insurance as an investment product, income earned through insurance products is generally tax-free at the time of maturity. Looks exciting, but the returns from guaranteed insurance products don’t go more than 6% per annum across the industry.
Let’s analyze mutual funds that is generally available for almost every investor of various risk appetites. Debt mutual funds are like fixed deposits, where the interest percentage is not fixed and it is totally governed by market conditions. If we see the past 5 years return of debt funds, they are also in similar range likewise FD returns. But, the taxation system totally differs here, if you hold the investment for more than 3 years. The returns are taxable @ 20% after giving the benefit of inflation. Let’s try to understand with an example. An amount of Rs 100 will grow to Rs 126 assuming 8% annual returns in 3 years. The income tax department in the past has given the inflation advantage of 3.8% per year in the past 5 years. Taking this advantage for three years for our example Rs 100 invested will be treated as Rs 109 and only difference of Rs 16 (Rs 126 – Rs 109) will be taxable @ 20%. The tax comes out to Rs 3.20 making you earn tax-free annual return of 7%. Further comparison between FD and Mutual fund is also worth mentioning here. In Debt mutual funds as you are taking market risk, you may get a higher return also, though vice-a-versa is also true.
Let’s move to next class, i.e. Equity Mutual funds. By investing in mutual funds, basically you are investing equity shares but in a much-diversified manner. Mutual funds don’t give you spikes and lows likewise individual stocks. One needs to understand the type of mutual funds and risks associated with each class while making investments. We will emphasize to understand on taxation part here. The tax rate on sale of equity oriented mutual funds is 15%, if you sell them within a year. It drops to 10%, if you hold your mutual investments for more than a year. Additionally, the Income Tax Act provides for exemption of Rs 100,000 every year on profits made through selling mutual funds.
In summary, the after tax real return on various investment products (assuming one is in maximum slab and invested for 3 years) would be as below:-
Type of Product
|Expected/assumed returns||Tax Impact||After tax returns||Inflation||Real Return|
|Bank FD’s and Post Office Schemes||8%||30%||5.60%||5%||0-1%|
|Insurance – traditional plans||5-6%||–||5-6%||5%||0-1%|
|Debt Mutual funds||8%||12-13%||7%||5%||2%|
|Equity Mutual Funds||8%||10% after exemption of Rs 100,000||7.2%||5%||2.2%|
To conclude, the taxation of the last two investment products provides you ample opportunity to save your taxes in a lawful manner and hold the key to the question raised at the beginning of this article. One needs to focus on earning income through tax-efficient products to reduce the tax burden in the future.
Saurabh Gupta is a practicing Chartered Accountant having qualified post qualification course in “Master in Business Finance” from ICAI. He has over 15 years of experience in finance and accounts domain. He specializes in strategic planning and implementation, financial control, fund raising, transfer pricing audits, tax planning & statutory compliances. He is having versatile corporate experience in retail sector and has worked in financial controller role with DLF Brands prior to joining practice.