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Direct Tax Code: Book Profits and Buy Back?

With the Budget revealing that the Direct Tax Code will be implemented from April 2011, a few choices have to be made now. The DTC brings in capital gains tax back again – even long term capital gains, which don’t get “preferential” treatment as they have in the last few years. Long term capital gains – where the purchase is over a year ago – is currently NOT taxed, and earlier they were only taxed at 10% max.

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:

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.

  • Kunal says:

    >This will be huge fluctuation in market if this is going to be implemented. T+2 days window also will not be sufficient because price movement will be huge. What is government intention in this(other than STT they will get due to huge transaction)? If i have shares worth crore rupees, shall i take risk to sell everything and buy back? i dont think so. What do you suggest, deepak?

  • Anonymous says:

    >Yes, in fact, I do have a crore worth of some company's shares. I don't want brokers and GOI to earn free money from me selling out everything and buying back again today.
    What I could possibly do is that I could just hold on for a long time, and when I retire (not age-wise, just say I quit job and want to enjoy life) – my income tax slab could well be made to show < 1.6L that year (or maybe I take a sabbatical(non-paid) for that year going places!) and *then* sell the shares that year and pay zero tax. How does that sound?

  • Deepak Shenoy says:

    >Your mileage may vary but honestly it's not within my lifestyle to live with 1.6L per year today. I'd say 6L or so would be reasonable – and then some to take a holiday etc. (Just thinking: Fuel 5K, Maintenance 3K, Eating out 10K, Groceries 10K, Phone/Internet 2K, help/car cleaning etc: 5K, Buying stuff 5K, random other annual expenses about 10K) This is assuming your house/car is fully paid for.

    For the 6-8L needed you'd pay 10% tax – that's about 50-60 grand a year. WIth the sell/buy back transaction on a crore worth of GAINS you'd pay about 1 lakh one time – which makes it worthwhile within two years.

    It's a personal calculation – for someone who is retired it might make a lot of sense to do this transaction once and save a heck of a lot considering liquidation has to be done going forward. For those whose retirement is too far away it might not be worth the hassle.

    I have shares where the gains are not spectacular – less than 50% – where I'm not going to do this deal; but where we have huge gains we'll do it just so we can save ourselves a tidy sum. Plus, it gives us a chance to rebalance the portfolio – I'll buy back a different set of shares in different weightages (that is a separate benefit)

  • Anonymous says:

    >Hi Deepak, I have some questions:
    1. The DTC is not final yet – Do you think the final version might change the capital gains tax laws?
    2. Do you know whether dividends from equity MF's will be taxable in DTC? If not, then dividend option becomes more suitable, right?

  • Deepak Shenoy says:

    >Anon: Yes, there may be changes in the final version but I expect equity gains taxation to stay.

    Dividends from Equity MFs are not taxable in the hands of the receiver (no dividends of any sort are, since the companies pay dividend tax on them at source.

  • Manish Mohan says:

    >Does new DTC also mean that I will be able to book long term capital loss? I have some shares that I don't have any hope for recovering from my losses. If I sell them post Apr 2011 will I be able to get the benefit of showing long term losses?

  • Deepak Shenoy says:

    >Yes, Long term capital losses will be admittable in the DTC. I'm not sure if capital losses of previous years can be carried over though, contact a CA if that applies…

  • Marshal Nagpal says:

    >Hello Deepak,
    What will be the case of ELSS MF and other MF invested from long period?

  • Deepak Shenoy says:

    >Marshal: At this point the DTC says they will be taxed (so will insurance proceeds)

    But that may change as the bill gets discussed

  • Anonymous says:

    >Anon said:"What I could possibly do is that I could just hold on for a long time, and when I retire (not age-wise, just say I quit job and want to enjoy life) – my income tax slab could well be made to show < 1.6L that year (or maybe I take a sabbatical(non-paid) for that year going places!) and *then* sell the shares that year and pay zero tax. How does that sound?"

    Isn't it actually, "Your income from Shares will be *added* to your existing income and *then* taxed at the appropriate slab?". Else, there can be many loop holes like one suggested. Why would someone do it any other way?

  • Deepak Shenoy says:

    >Anon: Yes, it will be added. But the commenter probably meant he will have no other income. Can be organised by investing cash only in dividend paying funds (dividends are not part of income).