Minimising Tax Implications VS Maximising Portfolio Return

Should you go for a product which is tax-efficient or something which gives higher returns but also is liable to higher tax? Here, we analyse two products

Advantage

Equity MF:

• Superior taxation
• No short-term capital gains tax

Advantage PMS

• Consistently outperform benchmark

Factors determining investment decision

• Past performance of fund manager
• The investment philosophy

Post-tax historical performance achieved

The wealth management process involves understanding the client's risk-profile, choosing an appropriate investment strategy, executing it efficiently, periodically reviewing performance and making necessary changes. Formulating a wealth management strategy involves maximising expected post-tax returns for a given level of risk. The level of risk, therefore, is a function of client’s appetite and willingness to take risk. Thus, it is of paramount importance that post-tax returns and not pre-tax returns are considered for optimising the risk-reward payoff.

A financial advisor should ensure that the investment strategy is executed in the most tax-efficient manner. Formulating and efficiently executing an investment strategy is followed by a performance reporting and evaluation. The financial advisor should be sensitive to the client’s tax status. In a nutshell, factoring the post-tax returns while optimising the risk-reward payoff and evaluating performance is the role of tax planning in the wealth management process.

For a majority of the retail investors, tax planning has revolved around Section 80C benefits, i.e., investments in ELSS schemes, Ulips and PPF. For a high networth individual, tax planning usually revolves around issues such as optimising post-tax risk-reward ratio, setting off capital losses, tax-efficient inter-generational transfer of wealth and tax-efficient transfer of wealth from business to personal/family trusts.

Different categories of investors will involve different levels of tax planning. For instance, taxation could be different for HNI, companies and trusts. Thus, on the basis of the legal entity of the client, appropriate advice should be given. For example, a financial instrument with higher pre-tax return, but lower post-tax return would be suitable for a client who wants to offset capital losses. The financial advisor also needs to understand the source of wealth, which could range from business income, inheritance, liquidating assets such as real estate and ESOPs, and so on. The proceeds from the above sources are subject to differential tax treatments. The advisor needs to ensure the deployment of these proceeds into other investible assets and need to carry it out in a tax-efficient manner.

Although tax planning is important, the investment decision should not be solely based on the tax-efficiency of the financial instrument or product. Investors tend to shy away from good investment opportunities, which are sometimes tax-inefficient, but yet can bring decent returns on investment. An example could be portfolio management services (PMS) offered by a number of broking and asset management companies. Taxation of a PMS is inferior to that of an equity mutual fund as the short-term churn in the portfolio attracts capital gains, which are not applicable in the case of equity MFs. The tax inefficiency of PMS when compared to equity MF should not deter an investor from allocating a portion of the investible surplus to those PMS schemes which have consistently outperformed the benchmark and a number 'tax-efficient' equity schemes. While making an investment in a PMS or an equity mutual fund scheme, an investor is basically investing in a professionally managed active equity strategy. In this case, what will matter is the past performance of the fund manager, the investment philosophy and the post-tax historical performance achieved. Therefore, if a particular PMS scores over equity mutual fund on these fronts, there should be no reason for an investor to be deterred from making that decision and allocating a portion of his surplus to it.

A similar example could be tax-efficient bonds such as Nabard and IIFCL. Secondary market Nabard purchases can yield as high as 8.75 per cent pre-tax for a tenor of eight years. The taxation is better than a coupon yielding bond or a fixed deposit due to capital gains treatment. Similarly, IIFCL bonds available in the secondary market with residual tenor of around three years can be invested at yields of around 6.7 per cent tax-free (semi-annual coupon payment), making it better than post-tax yields of fixed deposits of most banks. The significance of tax planning has only increased in the wealth management community. With the Direct Taxes Code (DTC) coming in from 1 April 2012 all wealth managers would have to view their client portfolios with a different perspective altogether. Even today, answers for questions such as “is the asset long-term or short-term", "is indexation benefit available for this investment", "what is the applicable tax rate”, are things which clients expect from their wealth manager. The DTC will also bring about a change in the products recommended to clients, especially in non-equity space. Debt-oriented mutual fund schemes, especially FMPs which enjoyed a tax arbitrage over fixed deposit or bond purchased directly from the primary or secondary market, will lose some of their sheen.

A number of wealth managers will be advising their clients on direct purchase of bonds with good credit quality and ample secondary market liquidity. This would require a lot of wealth management outfits to enhance their debt trading and debt research capability. Having said all this, there is a thin line between minimising tax implications and maximising portfolio return. One has seen many clients postponing take profit decisions so that the incidence of tax is low. If given the choice of saving tax or creating wealth, I would obviously choose the latter.