InvestorQ : What according to you is a better investment decision for an investor; direct investment in equities or going indirectly through mutual funds?
indhumathi Sayani made post

What according to you is a better investment decision for an investor; direct investment in equities or going indirectly through mutual funds?

shrinidhi Rajan answered.
3 years ago

Any investment decision is normally looked at from four basic criteria. The first criterion is the return that the investment is likely to generate over a longer time horizon. The second criterion is the risk that this return entails and obviously you want to minimize the risk per unit of return. The third criterion is liquidity and it implies that your investment should be able to generate liquidity at short notice without a big impact on value. The last angle is one of tax efficiency. We may not realize it but taxes make a huge difference to the effective post-tax returns that an investor earns.

The big question that confronts equity investors in India is whether they should adopt the direct equities route or go via the mutual funds route. Direct equities reduces the intermediation costs but then you need to have the wherewithal, time and patience to closely track and monitor your equity investments. For those who cannot manage that, equity mutual funds are a very good alternative to create long term wealth. An important question, therefore, is how equities and equity mutual funds compare as tax saving alternatives? While the tax treatment is similar in most cases, there are also some subtle differences. Here are 4 such cases where the difference in their tax treatment gets highlighted.

How equities and mutual funds compare in terms of tax breaks on investments…

When you invest in equities, there are no apparent tax benefits that accrue to you. Of course, there is the RGESS scheme which is meant to incentivize first time investors in equities, but that section has hardly been used and hence we shall not dwell on it. Mutual funds, on the other hand, do offer special tax incentives for specific investments. With the equity mutual funds category, there are specific set of funds referred to as Equity Linked Savings Schemes (ELSS). Any investment in ELSS qualifies for a tax exemption under Section 80C of the Income Tax Act. Section 80C has an outer limit of Rs.150,000/- per annum and includes other investments like insurance premium, provident fund investments, long term FDs etc. This is important because it substantially increases the post-tax returns. For example, assuming that an investor uses up his entire Section 80C limit by investing in ELSS, then he can invest up to Rs.150,000. He directly gets a 30% exemption (Rs.45,000). Therefore, his effective investment during the year is only Rs.105,000/- and this lower effective outlay will substantially enhance his post tax returns. This makes investing in mutual funds via the ELSS route highly productive from a tax perspective.

Let us first look at how equities and mutual funds compare in terms of dividends…

There is a subtle difference in terms of taxation of equities and equity mutual funds with respect to dividends. It needs to be remembered that when a company pays out dividend to its shareholders, it is required to deduct Dividend Distribution Tax (DDT) and then only distribute the net amount to shareholders. When you are invested in equity mutual funds, there is no DDT that is deducted by the fund. However, one can argue that the company in question would have already deducted DDT while paying to the fund and hence this purely amounts to avoidance of double taxation. Secondly, we come to the aspect of taxing dividends in the hands of the investor. This is where equity mutual funds have an advantage, especially for large investments. Dividends are tax-free in the hands of the investors both in case of equities and equity mutual funds. But in the Union Budget 2016-17 a new clause was inserted wherein direct equity dividends above Rs.10 lakhs per annum will attract tax at the rate of 10% in the hands of the investor. This will impact promoters and large shareholders. But there is no such limit for equity mutual fund dividends.

Let us also look at how equities and mutual funds compare on capital gains

Actually, in terms of capital gains there is no real difference between the way an equity share is treated and how an equity mutual fund is treated. Both equities and equity mutual funds define long term as a period above 1 year. In both the cases the LTCG is entirely tax free while STCG is taxed at the concessional rate of 15%. However, there is a slight difference in terms of flexibility. For example, the definition of an equity fund is that more than 65% of the assets should be allocated to equities. So a balanced fund with a 35% exposure to debt will still be classified as equity fund and get all the concomitant tax benefits of an equity fund. This allows greater flexibility to investors to infuse the stability and predictability of debt into their portfolio via balanced funds and yet enjoy the tax treatment of equities. However, post April 2018, both the equity funds and the direct equities are taxable at 10% on their long term capital gains without the benefit of indexation. In short it is a flat tax and just gives benefit of Rs.1 lakh each year as a basic exemption limit.

Let us compare equities and mutual funds purely based on the STT

The securities transaction tax (STT) was first introduced in 2004 and has continued since. Of course, the rates of STT have been progressively reduced but it continues to be a major cost for traders and investors. In the matter of STT, equity mutual funds appear to have 2 distinct advantages over pure equities. Firstly, when you buy or sell direct equities, STT is applicable on both legs of the transaction (purchase leg and sale leg). In case of equity mutual funds, there is no STT on the purchase leg but STT is charged only on the sale leg of the transaction. Secondly, equity mutual funds attract STT at a concessional rate. In case of equities, STT is paid at the rate of 0.1% of the value on both the legs of the transaction. In case of equity mutual funds, STT is paid only at the rate of 0.001% and that too only on the selling leg. This lowers the transacting cost of an equity mutual fund.

Prima facie, the equity mutual funds do appear to have a series of tax advantages over direct equities. However, we need to realize that equity funds are an intermediation and thus the cost of transaction in equities are already borne by the fund. Such costs, anyways, get passed on to the equity mutual fund investors. The big advantage for the mutual fund investor is that the taxation aspects have been kept at a much simpler level. That could be the big takeaway!