India has truly become a tax haven. If you are willing to take market-related risks, you can arrange your affairs in such a fashion that you don't have to pay even one single rupee as tax, irrespective of the extent of your gains.

And, it's all perfectly above board and legal! Here's how.

With a view to giving a boost to the Indian equity market, successive recent finance ministers have doled out many tax concessions to the income and gains from:

• Shares traded on a recognised stock exchange in India, and
• Equity-based mutual fund schemes (equity funds).

Now, all you have to do is to park all your investible funds in either of these two avenues -- and relax.

The dividends are tax-free, and so are all long-term capital gains. The only question that needs an answer is -- which of the two avenues should you choose?

Table 1 below presents a comparative gist of all the currently prevalent costs and taxes on shares and equity funds.

Table 1: Comparative Analysis between Shares & Equity Funds

Let us compare these two avenues, item by item. At the first glance it might appear that equity mutual funds are superior to direct investment in shares because:

1. You don't have to pay brokerage for equity funds whether at purchase or sale. This, however, is more than offset by the entry/exit loads and AMC (Asset Management Company) fees.

2. No STT (Securities Transaction Tax) for mutual funds at purchase. This is compensated by double the STT at sale by mutual funds. Good for long-term investors in mutual funds.

3. Mutual funds are exempt from Dividend Distribution Tax (DDT) of 16.995%. (The Finance Act 2006 extended this benefit to closed-end equity funds as well.) Don't get overly lured by this, however.

DDT is charged to mutual funds when they receive dividends from companies they have invested in. Charging DDT to you when you receive any dividend from a mutual fund would amount to double taxation.

Personally, I don't like either the dividend or the dividend reinvestment options of mutual funds. The quantum of dividends paid, whether by mutual funds or by companies, is, both, variable and uncertain, rendering the planning of day-to-day expenses difficult.

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The growth option of mutual funds bypasses this difficulty. The growth option is better than the dividend option only for this one reason and not because it bypasses DDT by converting the dividend into growth. Purely from a taxation point of view, the two options are equivalent since in both cases there is no DDT, the dividend is tax-exempt, and so are the long-term capital gains.

The real edge equity funds have over shares for most investors

As we saw from the above comparison, there isn't much to choose between shares and equity mutual funds so far as their respective costs and taxes go. Yes, mutual funds charge loads to cover their expenses of market transactions and also a small fee for nursing and monitoring your investments. But it is worth paying the price because:

1. Mutual funds make personal monitoring unnecessary: Mutual funds undertake the rigours of the monitoring and keeping tabs on your portfolio. You receive the benefit of their expertise in handling and tracking the market.

2. Mutual funds are akin to savings bank accounts: When investing in an open-ended equity fund scheme, an investor can deposit money any time s/he has investible funds and, similarly, can redeem, partly or fully, any time s/he needs funds. The repayment is effected within 5 working days at most. Thus, such schemes have virtually become savings bank accounts -- and with tax-free returns, to boot.

3. Systematic withdrawal facility: A good strategy is to withdraw as much as you need at some fixed periodicity of your choice. For instance, you may withdraw on a monthly, quarterly, 6-monthly or annual basis to meet your expenses.

Tax-smart: Zero tax even on short-term capital gains

If you are forced to redeem your mutual fund units in the short-term horizon, namely within 12 months of their purchase, whether partially or in full, tax is payable @ 10.3% on any short-term gains thus made.

Can we avoid this? Let us see how:

Remember that you have parked all your investible funds in the growth option of an equity fund. Now, imagine that you had a capital of Rs 100 lakh (Rs 10 million) with which you bought 10 lakh (1 million) units of Rs 10 each. Suppose the NAV (Net Asset Value) has grown by 10% to Rs 11 per unit, and thus the value of your investment has become Rs 1.10 crore (Rs 11 million). Of this, you redeem 90,909 units worth Rs 10 lakh (Rs 1 million) before 12 months, which still leaves your original investment of Rs 100 lakh invested in the mutual fund intact.

Now comes the best part.

The short-term capital gain you have made is Re 1 per redeemed unit, i.e. Rs 90,910. You have no other income. The tax threshold, below which no tax is payable, is Rs 110,000. Ergo, you have Rs 10 lakh (Rs 1 million) for your household expenses from short-term capital gains - and, at zero tax!

Convinced now that India is truly an incredible tax haven for an informed investor? The only pre-condition you need to fulfill in order to benefit from this big-bang tax break is to familiarize yourself with the basics of investing in equity funds and grasp some simple strategies that can significantly reduce the market-related risk of equity investing.

• Guidelines to filing your income tax return
• How to design a tax-smart salary package

Excerpt from:

Taxpayer to Taxsaver (F.Y. 2007-08)

By A N Shanbhag

Publisher: Vision Books

Price: Rs 235.

A N Shanbhag is a best-selling author and a very widely syndicated columnist on personal finance and taxation.

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