What is Tax Arbitrage?
The difference in tax rate due to various reasons on similar investments is tax arbitrage. That means two or more types of investments are earning similar rate of returns whereas you are paying more tax on one type as compared to other types.
How do you gain?
You will gain if you choose the lower taxed investment. However, the savings could differ from one individual to another depending upon which tax slab your income falls in. For example if your income is falling in highest tax bracket i.e. 30%, you may gain more as compared to others whose incomes are lower and fall in lower tax brackets of 20% or 10%.
That gives you all the more reason to read this carefully and implement for yourself.
Where is this arbitrage available and how to make use of that?
If you invest your funds in bank FDRs which is earning an interest of 8.5% p.a.and if you are taxed at 30% the net return on your would be calculated as => 8.5% minus tax i.e. 30% of 8.5% = 8.5% minus 2.55% = 5.95%. You may be surprised but this is the net rate of return which you are receiving currently.
Now the question is - how this return can improve?
There are similar variable interest bearing instruments called Debt / Liquid Mutual Funds which earn similar returns as compared to FDR but are taxed at much lower rates if the funds are invested for more than a year. The sample calculation of return from a debt fund is as under:
Gross Gain on Debt / Liquid MF earned in a year = 8.5%
Capital Gain on Debt MF would be calculated after indexation of purchase cost, if sold after a year as this is treated as Long Term Capital Gain (This is not taxed as interest)
This gain after indexation would be either zero or negative and there would be nothing to pay tax on.
Hence the Net return on Debt MF, if growth option is chosen = 8.5% p.a.
The growth option does not give your earnings in instalments and is paid to you at the time of closure / withdrawal of the fund. You may choose dividend payouts also, but the tax arbitrage is not applicable as the dividend is taxed at a higher rate.
Additionally, if there is any long term capital loss as calculated above, the same can be used to set off other capital gains (non STT paid) and can reduce your tax liability further.
In case, there is any gain after indexation as calculated above (though the chances are almost zero in the present infaltion situation), it would be very less and the tax would be payable on that @20% regardless of your tax slab and therefore the return would be high as compared to FD.
How safe are Debt / Liquid MF as compared to FDR?
This is almost as safe as FDR and can be relied upon.
Additional Advantage in cash flow planning?
This offers additional advantage when you are unsure of the period for which the money can be spared for investment by you / you are saving for some specific objective in mind such as purchase of car / house / marriage / education of children etc. and not sure when you may need the funds. In FDR the return is linked to period of investment which is high if the period is 1 or more years and could be as low as 6% if the period is less e.g. 3 months or so and if you pre-mature your FDR, there is a interest rate penalty which reduces the return.
In Debt / Liquid funds, the return is earned daily and would not vary due to period / duration of investment. Therefore, if you plan to keep your money for undefined period, the rate would not be affected much due to this inability to predict the duration of investment.
Needless to mention that you can now call your MF agents if any and learn about these even more.
The difference in tax rate due to various reasons on similar investments is tax arbitrage. That means two or more types of investments are earning similar rate of returns whereas you are paying more tax on one type as compared to other types.
How do you gain?
You will gain if you choose the lower taxed investment. However, the savings could differ from one individual to another depending upon which tax slab your income falls in. For example if your income is falling in highest tax bracket i.e. 30%, you may gain more as compared to others whose incomes are lower and fall in lower tax brackets of 20% or 10%.
That gives you all the more reason to read this carefully and implement for yourself.
Where is this arbitrage available and how to make use of that?
If you invest your funds in bank FDRs which is earning an interest of 8.5% p.a.and if you are taxed at 30% the net return on your would be calculated as => 8.5% minus tax i.e. 30% of 8.5% = 8.5% minus 2.55% = 5.95%. You may be surprised but this is the net rate of return which you are receiving currently.
Now the question is - how this return can improve?
There are similar variable interest bearing instruments called Debt / Liquid Mutual Funds which earn similar returns as compared to FDR but are taxed at much lower rates if the funds are invested for more than a year. The sample calculation of return from a debt fund is as under:
Gross Gain on Debt / Liquid MF earned in a year = 8.5%
Capital Gain on Debt MF would be calculated after indexation of purchase cost, if sold after a year as this is treated as Long Term Capital Gain (This is not taxed as interest)
This gain after indexation would be either zero or negative and there would be nothing to pay tax on.
Hence the Net return on Debt MF, if growth option is chosen = 8.5% p.a.
The growth option does not give your earnings in instalments and is paid to you at the time of closure / withdrawal of the fund. You may choose dividend payouts also, but the tax arbitrage is not applicable as the dividend is taxed at a higher rate.
Additionally, if there is any long term capital loss as calculated above, the same can be used to set off other capital gains (non STT paid) and can reduce your tax liability further.
In case, there is any gain after indexation as calculated above (though the chances are almost zero in the present infaltion situation), it would be very less and the tax would be payable on that @20% regardless of your tax slab and therefore the return would be high as compared to FD.
How safe are Debt / Liquid MF as compared to FDR?
This is almost as safe as FDR and can be relied upon.
Additional Advantage in cash flow planning?
This offers additional advantage when you are unsure of the period for which the money can be spared for investment by you / you are saving for some specific objective in mind such as purchase of car / house / marriage / education of children etc. and not sure when you may need the funds. In FDR the return is linked to period of investment which is high if the period is 1 or more years and could be as low as 6% if the period is less e.g. 3 months or so and if you pre-mature your FDR, there is a interest rate penalty which reduces the return.
In Debt / Liquid funds, the return is earned daily and would not vary due to period / duration of investment. Therefore, if you plan to keep your money for undefined period, the rate would not be affected much due to this inability to predict the duration of investment.
Needless to mention that you can now call your MF agents if any and learn about these even more.
These are my personal views and should not be considered as legal advise. You are requested to consult a professional before acting on this blog.
For any query / suggestion on my blogs, feel free to write to me at piyushsgarg@gmail.com.
