E11: Importance of Tax Planning | Learnings from wealthy on Mutual Funds, Capital Gains | Changes in crypto taxation

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In the eleventh edition of Insider Investing, we discuss a topic that affects all our personal finance and investing decisions- Taxation. Our Co-Founders Sandeep Jethwani & Vaibhav Porwal break down strategies and best practices used by the ultra-wealthy to optimise their taxes on their investments as well as income.

Tune in to learn the latest rules around taxes on capital gains, strategies like Tax loss harvesting used by HNI's and how gains on different instruments like equity and fixed income are taxed. We also cover new age topics like ESOP taxation, taxes on Crypto and other best practices like tax deferment that investors can use for tax planning.

Timestamps -

00:00 - 02:29 Introduction

02:30 - 03:31 Tax strategies of HNI's

03:32 - 06:23 Optimizing tax on salary

06:24 - 08:51 Fixed income vs. ELSS

08:52 - 11:52 ESOP taxation

11:53 - 15:20 Exercising ESOPs

15:21 - 15:52 Tax deferment

15:52 - 19:02 Taxes on capital gains

19:03 - 26:02 Capital gains

26:03 - 29:20 Crypto taxation

29:21 - 30:59 Tax loss harvesting

31:00 - 33:16 Conclusion

Episode Transcript

Sandeep: Welcome to episode 11 of insider investing. On this episode, we cover a very interesting topic, which affects all our personal finances and investments, which is taxation over the last 15 or 16 years, Vaibhav and I have worked with the ultra wealthy and absorb certain best practices when it comes to how they optimize taxes, when it comes to their portfolios and their income.

One of the most interesting things we cover on this topic is the new changes on taxation. When it comes to crypto, the concept of tax loss, harvesting, and how we can use deferment to our advantage to optimize our taxes.

Sandeep: Hi Vaibhav, Welcome back to Episode 11 of Insider Investing. You know, there's one thing that I realized earlier today, and today's we are recording this on the 13th of March. It's a Sunday and I realized that I haven't figured out my advanced taxes for the year. And it's that sinking feeling that you get because now you have to figure out how to get the money to pay the tax. And I feel every year that I could have been a little smarter about my tax planning, having advised a lot of HNI's in the past, I feel that potentially all of us are not as on the ball on our taxes, as the ultra wealthy are. And today, I thought it would be good for us to cover the best practices. What are the things that we should be thinking about? We all know that you are a chartered accountant. I am not. I've just done finance and strategy. But I think it's important also, for me to say right at the top of the show that all that we discuss here is not specific tax advice. It is our learnings from having dealt with high net worth individuals about how they manage their taxes. So what I would strongly encourage is for each one of us to consult our own tax advisers before we act on this, that said, Vaibhav, welcome back again to the show. 

Vaibhav: Thanks Sandeep, 

Sandeep: What is the one big thing that you feel that the wealthy do when it comes to taxes, but that each one of us don't? 

Vaibhav: Interesting questions Sandeep, and it's the season of taxation. Everywhere I go, I read about investing in equity linked saving schemes to save taxes. We get enough calls from different advisors who are advising on investing and tax planning instruments, to your point on what high net worth individuals do versus what most of the other investors do is to focus on two things. 

A, they convert their income largely into capital gains, and capital gains have preferred tax treatment versus any other category of income. 

And B, they don't pay taxes very frequently. And maybe in the subsequent part of this podcast, we can touch upon both of these points. 

Sandeep: Yeah, I think what you mean by that is that they pay taxes, but they plan for

their taxes, I think let's go a little deeper in that. And let's think of taxation at two levels. One is when we earn an income from our core profession, salary and other things. And then the second stage of taxation occurs when we have invested that money, and we get gains out of it. So let's first focus on the sources of income. And let's begin with what most of us have as a primary source of income, which is our salary. How do you think we should be thinking about optimizing our salary or tax on the salary income? 

Vaibhav: So it's a great point on the path and unfortunately, all of us know that there are very few avenues available to save taxes because your deductions are restricted in a large way. Select deductions are allowed, nothing beyond that. But look at it from the government's perspective, and that will possibly help our users better in deciding how they should plan the taxes. What the government is telling you when you earn salary income is to give you deductions on two accounts. Either you help in capital formation, okay?

That you can do by investing in select investment schemes. And making these investments will allow you to save taxes or certain nature of expenses, which are unavoidable and critical for the assessee. If you spend money on those expenses, the government will give you a deduction on taxes. So broadly, you can classify tax planning tools into parts, investment related tools and expense related tools and investment related tools if you invest in equity linked savings schemes, which means you're contributing to capital formation in equities that will give you a benefit of deduction. If you invest in fixed income schemes, which are promoted by government in form of EPF, or NPS, where you're investing money for long term, and helping government mobilize resources for the growth of a country where you get benefit on taxes, or on expense side, when if you have some critical expenses, which you are incurring, whether it is education of your child, which again, is important on the development of skill side, or you are spending money on any kind of potential liability, which may occur to you in terms of health insurance in terms of life insurance. So that's how the government is looking at it. And that will possibly help our users better in deciding which way they want to move. 

Sandeep: Yeah, I think that's a great framework Vaibhav, one is you said that there are certain tax benefits that you get on account of doing the right investments. And the second is by capturing some of your expenses correctly. Yeah, I think expenses, like you said, are typically the unavoidable ones, you won't incur an expense just to save tax. Yeah, but on the other hand, in the first category, which is the category of investments, there is a lot of optimization to be done. We have written about this in the past where this whole thing that ELS is always right for you, is a question that needs to be asked. There are some cases where each one of us have a part of our allocation to fixed income, and their fixed incomes, returns from the PF schemes are potentially better on net of tax basis than what I would get from other fixed income opportunities. Yeah, therefore, it may be important to prioritize fixed income investing out of this pool, as opposed to equity investing out of the tax savings pool. What do you think of that? 

Vaibhav: No, that's an important point, Sandeep. And I'd also thought about it, when you and her today's a great day to have this conversation where I read this article that the government has reduced rates to 8.1%. But 8.1% post tax in an era where FD returns are down to 4.5% percent is a great alternative to any fixed income instrument, especially because it comes with government of India guarantee. They're not taking any kind of risk, and still generating 8.1% Post acceptance. Yeah, we discussed this in the past and in equity, the return differential between ELS schemes and normal equities aims is negligible or not there. But in the case of fixed income instruments, the return differential itself is large enough for you to consider an ETF over ELSS and select cases. So that's the framework with which I think our investors should think in case they have limited capital, they want to optimize that for long term then obviously equities, the better asset class, but in case they have reasonable amount of capital, where they have ability to allocate money across asset classes, priority when it comes to tax planning instruments should be given to fixed income, correct? 

Sandeep: Absolutely. And that's a very helpful construct for each one of us to be aware, especially as we are in the last 10-15 days of this financial year to make that investment. The other point is now let's focus on another type of income that we get at the top before we get into the investment tax understanding, which is the income that we get on account of Aesop's. Now the interesting thing is that very few people know that you get a quote, unquote, deemed income or income is assumed to have been arisen. The moment you exercise ESOP's. Yeah. And that's a very strange concept. We were having this conversation in our office when one of our colleagues was exercising her ESOP's from a previous company. Yeah. And she was not able to reconcile the fact that she has to pay tax on that. And the most interesting part is most of the time this tax outgo is much more than what you're paying to buy the ESOP's. Yeah, let's explain this concept of perquisites tax Vaibhav, because I think it is an underestimated part of the gains that you get from ESOP's. Yeah. 

Vaibhav: Great points Sandeep, All of us have gone through that heartache of paying disproportionate taxes on ESOP exercise. What the government here is trying to say is that if you have got your ESOP's at a certain price, and today's fair value is significantly higher than your strike price, then the difference between the two should be deemed as perquisite. You're getting that benefit, because you work for the company. And because that expense is deductible for the company. The recipient of ESOP benefit should be paying tax on that income.

So, let's build on this through an example, if you get shares of a company ESOP's of a company at 10 rupees, okay at the point of exercise, if the fair value of the stock has gone up from 10 rupees 100 rupees and 90 rupees is a benefit that company is given to an employee against that benefit companies claiming expenses in their profit and loss account. Now, government is saying we can't lose taxes at both the ends if companies claiming expenses then someone has to pay tax on this income. So, therefore, the beneficiary which in this case is employee is expected to pay tax on this notional gain of 90 rupees now, why I'm calling it notional is because, in most of the cases employees choose not to liquidate the either they choose not to liquidate or they don't have any liquidity in the stock of the company where they can get realization. 

Sandeep: Yeah, absolutely. So, this is an interesting point, imagine a situation where like the example that you gave, I have invested 10 rupees to get this stock, I have got stock worth 100 rupees, so, on the 90 rupees let's assume we pay tax of 30% So, 27 rupees goes out as tax. So, I have paid not that not only a 10 rupees, but also 27 rupees, so, outgo from my side is close to 37 rupees. Okay. Now, while I've got stock worth 100, your point is that if that stock is not saleable, if I'm not able to liquidate the stock, how do I pay for the 37 rupees which I had to pay for getting these options, and which is why one of the clear things that we see as a behavior among smarter people who understand ESOP's is that they exercise ESOP's only when a either there's a liquidity or second where the ESOP is about to lapse, and you cannot exercise it after a certain date, and you don't have a choice. That is the time you exercise ESOP's. And the other point is also when you were referring to this when you talked about how the wealthy manage this is that they defer the tax as much as possible. And same thing with ESOP's, you exercise the ESOP's as late as possible, unless one of the two situations arises, which is a there is a liquidity event happening, your company is up for sale, the stock is listed. So you can transact on the stock or there is a buyback or some such event is happening. So either in that situation, or if I have left the company or my vesting period is coming to an end. And I don't have a choice but to exercise 

Vaibhav: There also you will exercise only if you see meaningful upside, you will have to do cost benefit analysis in this given example,

you're paying 37 rupees where the fair market value is 100 it makes sense to exercise. But imagine a scenario where your exercise price is 10 rupees and fair market value is 20 rupees, it may not be beneficial to exercise. So each scenario should be evaluated on a standalone basis depending on the details of the situation. 

Sandeep: Yeah, and the other the last point on this perquisites amount is that this cane of 90 rupees gets added to your regular income in that year. And can has the potential of changing the tax slab for your entire income. Yeah, so you might have a situation where as we know that at different slabs, the surcharges change, or the tax rates change. And after a certain point, the surcharges change, right. So as your income level goes higher, you pay a higher amount, higher percentage of tax. If because of the exercise of ESOP's, you have a larger perquisites tax, you end up in a situation where you're on your overall pool, you are ending up paying a higher amount of tax. And this is something which causes a lot of heartache, especially when going back to the point that you don't realize this income, you're not getting the income and yet you have to pay tax, you have to pay a higher rate of tax on your other income just because this happened. So the ESOP taxation is a conundrum of its own. 

Vaibhav: Now the government is becoming sensitive to this and they've allowed certain startups to defer taxes at the point of sale. So which is a positive step? I'm hoping that sooner or later the government will allow all the companies or all the employees to defer their tax.

Sandeep: Yeah, we will be strong proponents of that, because for our employees, for all the startups in the ecosystem, and India as a startup economy, I think that will be a huge, huge positive. 

Vaibhav, now let's switch gears to the investing side. And this is something that you and I have seen very, very closely that when it comes to their money, the ultra wealthy factor in taxes in a major way when deciding where to invest, or taxes don't guide the investment necessarily by themselves, but they are an important factor in that. And one of the biggest focus areas that I've seen the HNI's work on, is the concept of tax deferment that you will pay tax only when you know as late as possible. Let's talk about this a little bit in the context of how taxes are paid in India on the capital gains. 

Vaibhav: So let me explain this with an example. So let's take a scenario of two portfolios. Now one portfolio is managed directly by an investor and the second portfolio is managed through a mutual fund scheme where you have an option to postpone your tax liability, let's say in both the cases you start with 100 rupees after one year, you have generated a gain of 20 rupees in both these portfolios. In the first case, you decide to book the profits to move into other stocks, because you believe that you realize maximum potential from this investment, you should change the composition of the portfolio. The moment you do that, you are subject to tax liability on the gains of 20 rupees, which if I take an ideal scenario will be a 12% tax or 11% tax including surcharge on long term capital gain or a most likely case would be a 13-14% tax, because some of the transactions would be short term in nature. So, end up paying 13 to 14% tax on a gain of 20 rupees. So, that is your capital which is available to grow in the next year goes down from 120 rupees 117 rupees. Correct. In the second case, when you invested the same amount in a mutual fund scheme, the fund manager gets this feeling that he needs to change the portfolio, he will change that portfolio within the scheme without you having to pay any tax. And because as all of us know that mutual funds on their internal transactions is not subject to pay any taxes, there is no drop in the deployed capital for investors who invest through mutual fund. If you keep running this cycle, year after a year, over a 10 year period, there can be difference of one and a half 2% per annum on returns purely only on account of ability to defer the taxes at 18% Return versus 20% return can be outcome and you know over a long period of time 2% compounded year after year can have a difference of 40-50% on your initial investment capital. So that's that investors think about deferment, your

objective is to maintain the dynamism without necessarily having to pay taxes at regular interval. 

Sandeep: I think this is a very important point. And I think it arises from one concept of taxation.

Which is that when it comes to capital gains or investment gains, taxes are paid only when the income is booked, as opposed to on the value of the asset going up. Yeah, at least for individual investors, people like you and me. If my portfolio goes from 100 to 110, we don't have to pay tax on the 10 rupees unless and until we booked those gains or we sell those instruments to get the profit in our account. Yeah. And which is why sometimes there is this concept of periodic booking of gains, it is a psychological comfort that you get, you might actually be worse off from a tax perspective because you are paying taxes much earlier than you need to. Now when it comes to mutual fund, can you give an excellent example on direct equity investing versus mutual fund investing in equities, where the taxes need to be paid in case of mutual funds when you exit the mutual fund one or two or three years later. Whereas in case of stocks, if you're trading on the stock portfolio, you will pay tax on a year on year basis. The differences actually were far more acute when it comes to fixed income or debt mutual funds or debt investing in case of debt funds are dead, things like bonds, fixed deposits, etc. You are paying tax practically on a monthly or a quarterly basis because that income is getting booked in your hands on a monthly or a quarterly basis when it comes to fixed deposits. But when it comes to mutual funds, if you're invested in the Fund for say one or two years, you are paying tax only when you sell out on the units of the fund. So you're definitely or tax from a quarter on quarter basis to maybe two or three years later. And the last thing is that the magic of the tax rates, when it comes to debt mutual funds, more than three years, you get taxed at a lower rate and you are able to get the benefit of indexation. So on the debt side, and maybe Vaibhav, you can illustrate this better on the debt side, the gap is actually much higher than it is on the equity side. 

Vaibhav: No, great point Sandeep and fixed income investing is something which signifies the point of tax paid by wealthy individuals versus people like us to the maximum levels, I've yet to come across a high net worth investor who keeps money in fixed deposits of man, because they understand the fact that when they keep money in interest bearing instrument, they have to pay tax at marginal rate of tax, the moment they use mutual fund as a platform or as a vehicle, they can convert that interest income into a capital gain, and government is far more sympathetic to capital gains versus interest income. So again, let me use an example to simplify it for our listeners. So imagine you have 100 rupee to invest you invest in a bank FD at 6% rate of interest, every year, you will get payout of that interest. Income Tax recognizes that income as income or current financial year, the moment you realize that return you have to pay or even if you don't realize that return, you have to pay tax on approval basis. So in case you've invested money for nine months, basis, nine months, you'll have to pay tax on that income. So if you're invested 100 rupees, if you generate six rupees on that you pay tax, let's for a moment take 30% as rate of tax, your return after tax will go down to 4.2%. Again, the same logic of no deferment, next year, starting with a base of 104.2 and you're generating 6% on that, again, you will pay tax and once you complete a cycle of three years, you will have about 113-114 rupees as your net of tax returns impact. Now imagine you invest the same money into mutual funds and take three years holding period. And instead of receiving your income in form of interest income, you receive your income at maturity in form of capital gains. There are two advantages. One there is deferment because, as you mentioned, you pay taxes only when you realize your income be you get a benefit on account of indexation. Indexation is nothing but government is giving you relief. To the extent inflation is prevalent, or impacting your value of money. So using the same example, if you're generating 6% in debt mutual fund for three year, but because inflation is five year 5%, average or three years, year after year, you will be paying tax only on 1% return and that too at a subsidized rate of 20%. In the same example, if you invest money, in the same bank instrument using mutual fund as a platform after three year instead of 113. In the first example, net of tax, the money which you'll receive in hand will be 117-117 and a half. So the difference is 3.5- 4% over your investment tenure which becomes larger and larger as you keep increasing your investment tenure. 

Sandeep: Yeah, it's a very interesting point, you know, three and a half 4%. But on one hand, you had 113 and on the other hand, you had 117. So you've actually made four rupees extra on a base of 13, you're potentially making 30% higher gains than you would have done in case of fixed deposits. And you're absolutely right, rarely ever have we come across an ultra wealthy individual who has kept money in fixed deposits. They're always preferring mutual funds on that side. And the same thing applies in case of stocks, stocks versus mutual fund equity investing mutual fund equity investing ends up scoring above stocks for this very reason. Now, let me go back to one major asset class which seems to be getting everyone's attention. And obviously, we are waiting for the regulator's to bless it as a regulated instrument to be able to invest in but as a digital asset now the current budget recognized crypto, and for the first time starting first April, these will be taxed in a different manner. Vaibhav explain to everyone the concept of taxation when it comes to the TDS element. And when it comes to how when the gains are booked on crypto assets. 

Vaibhav: So first, let me cover the TDS part. Government wants to bring income which is generated by crypto investors under the ambit of tax and therefore, they have introduced the concept of tax deduction at source. Every time you will sell your crypto positions, the exchange through which you are trading will have to deduct TDs at the rate of 1% that 1% allows government to capture your transaction in your annual income statement.

On the taxation side government is obviously there are a lot of ambiguities which needs clarity from the regulators in terms of what will be the treatment of the outstanding gains on 31st March, for example, if you bought a Bitcoin $1,000 on on 31st March, the price is $38,000. Do we still have to pay gains taxation from 1000, or we'll have to pay taxes from $38,000 onwards is here to be clarified by the government. But on a fundamental basis, what government is saying is, the treatment of taxes will be very similar to how government treats taxation on lottery, or speculative gains, where you pay a flat 30% tax on gain regardless of your income tax slab. So even if, on your normal income, you are paying no tax or 5% tax or 10% tax, you will still have to pay 30% tax on your gains from crypto investing. 

Second, you won't be able to carry forward any losses. 

Third, you won't be able to offset your gains in crypto against losses in any other asset class. Typically, as you know, we can offset intra categories or inter categories, gains and losses. But in this case, offsetting will be allowed only within the same segment that to within the same year. So if you have

profits on Ethereum, and losses on Bitcoin in the same financial year, you will be able to offset. However, in case your gains in Bitcoins have got realized in this financial year, whereas your losses in Ethereum getting realized in the next financial year, you won't be able to offset. So government is very clear that they want to bring in this income under the ambit of tax and also has introduced an extremely tough tax regime for this asset class.

Sandeep: Yeah, and therefore, it's very important for those of our listeners who are investing in crypto assets, to now have the right tax advice when it comes to this part of their portfolio. And I am sure that the chartered accounting community will come up to the challenge and they will understand the taxation. Because as I read somewhere recently, nearly one crore investors in India have taken exposure to crypto assets, which means a lot of more work for Chartered Accountants all over the country. The last part Vaibhav, and this is something that we hear in popular discussion is this concept of tax loss harvesting. And while it's not our place to recommend for, or against it, it's important to understand what it is and why people do it. And maybe, I think, especially in a time when this quarter as we speak, a lot of stock portfolios are down.

Let's go a little deeper into understanding what is tax loss harvesting, whether right or wrong, why do some investors do it?

Vaibhav: There are two ways in which typically tax planning or tax optimization can be done, let's not use the word planning because people may perceive it negatively, but tax optimization can be done. So first is up to one lakh rupees of long term capital gain. There is no tax incidence, okay. So we recommend to all our investors that if we are sitting on gains, and they have not booked any gains in the current financial year, at least up to an extent of one lakh rupees, they should move gains so that it becomes exempt from any kind of tax. Second, in case you're sitting on losses, you can book those losses today and carry forward these losses for a period of eight years to offset against any potential future gains. So which is exactly what tax loss harvesting as you enter into a transaction today to carry forward tax capital losses in your balance sheet for a period of eight years, which you can utilize to offset your future tax liability. 

Sandeep: Yeah. And you know, the important thing, however , is that this is not as easy to execute as it sounds. If I have one stock, which is sitting at a loss, I sell it to book a loss with the view that I will buy it back. What I often see is that, you know, investors don't end up buying it back instantly. You end up buying it back either a few days later, you want to stagger your purchase. All of that confusion happens. And sometimes you miss the big picture that you wanted to hold the stock in the first place for long

term gains. So I think, important to be aware of the concept of tax loss harvesting, but certainly not. You know, it doesn't probably work for everyone that we know. Absolutely. And I would prefer the first approach over the second one where at least to an extent of one lakh rupees, you save taxes. No, this is very helpful Vaibhav. I think, from for me two big takeaways, 

First, That each one of us needs high quality tax advice to ensure that our portfolios, we are not paying extra tax, and also even at the top when it comes to our income, we are handling our taxes better. 

The second, and that's an equally important takeaway for me is that how much do investment professionals, advisors, wealth managers, distributors, need to know about taxation? Because to be able to recommend the right set of instruments to your client, you need to know how taxes work on that note, thank you Vaibhav again. And we look forward to doing this again very soon. 

Vaibhav: Great, great. Thanks. Thanks a lot Sandeep. 

Sandeep: We hope you enjoyed tuning in today and got some great takeaways. You can listen to the episode on our website, or wherever else you listen to your podcasts.

If you wish to reach out to us follow dezerv on LinkedIn, or you can write to us at social@dezerv.in

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