Until now , investors had only a few options to claim tax exemption on their capital gains. They could invest in bonds of National Highways Authority of India or Rural Electrification Corporation or they could buy a residential property. The Budget has given investors two more options. Individuals will now be able to save tax on capital gains by investing in start-ups directly or indirectly. However, these options carry much higher level of risk and investors should look at them if they have the requisite risk appetite.
Current tax-saving options
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The Income Tax Act provides for three types of tax-saving options. Under Section 80C, the investor gets a deduction for investing in eligible instruments. Under Section 87A he gets a tax rebate, wherein the tax that he is liable to pay gets reduced by the applicable amount. Then there are a range of options available for saving tax on capital gains. To avail of this benefit, the investor has to reinvest the capital gains he has earned into specified instruments.
New options
The Budget has introduced two new options that will enable investors to save tax on capital gains. Under Section 54EE, investors may invest in a fund-of-funds, which will in turn invest in startups. The government plans to raise Rs 2,500 crore annually for four years (Rs 10,000 crore altogether) in these funds. If investors reinvest their capital gains in such an approved fund, they will be exempted from paying tax on those gains. This investment avenue comes with a couple of pre-conditions. The amount you may invest shouldn't exceed Rs 50 lakh. The investment will carry a three-year lock-in and premature withdrawal will result in the tax benefits being reversed.
Under Section 54GB, if a person reinvests the long term-capital gains earned from the sale of a residential property in an eligible start-up, then again he will become eligible for exemption on those gains. This provision too comes with a couple of conditions. The individual investor should hold more than 50 per cent share in the start-up. In other words, he should be the majority shareholder in the entity. Second, the start-up should have utilised the amount to purchase new assets before the due date for filing tax return. What this effectively means is that small, minority and passive investments in start-ups will not make you eligible for tax benefit, and the amount invested by you must be effectively deployed by the start-up.
Higher-risk avenues
Both these new investment options represent a sea change from those that have existed traditionally for saving on capital gains. One option available has been to reinvest in a residential property, and the other has been to invest in certain eligible bonds. Investors have been comfortable using these options because they don't carry much risk. In the case of bonds, there is no risk to your capital. In case of residential property, too, there is only a very small chance of the value of the property dropping. Moreover, the investor has the freedom to either live in the property himself or rent it out.
These two new options are completely different because they are akin to equity investments, but with a higher degree of risk, since your capital will be invested in a start-up. While there is always a chance that you may receive a bigger payout a few years down the line, there is an equally high risk of the value of your investment getting eroded. As all of us intuitively know, new ventures carry a high degree of risk.
The failure rate among start-ups is very high, hence it is quite possible that you could end up losing the capital you have invested. The probability of loss is even higher when you invest in a start-up yourself, instead of via the fund-of-funds route. The latter at least offers the benefit of diversification. When you invest the entire amount in a single venture, you could lose all of it if the venture fails.
Check risk appetite
Different individuals have different levels of risk tolerance. The good thing is that now you have a bouquet of products available carrying varying degrees of risk and return. Closely examine your level of risk tolerance and choose an option that suits your risk appetite.
A very conservative investor who does not want to put his capital at risk should opt for the existing capital gains tax saving bonds.
Such an investor should be content with their relatively low rate of return. Conservative investors with a longer term outlook may consider the option of buying a property. Those with a moderate appetite for risk may opt for the fund-of-funds route, which provides some degree of safety via diversification.
Here, the investor gets access to a diversified portfolio of start-ups of which some may fail and some may succeed, but at the end of the day the investor can to come out a winner. Finally, at the high end of the risk spectrum is the option to take a majority stake in a single start-up. Here, the downside risk is huge, but the payoff can be equally spectacular if the venture succeeds.
TAX TREATMENT OF CAPITAL GAINS
- If you earn long-term capital gains from sale of assets, you become liable to pay capital gains tax
- Residential housing and capital gains tax-saving bonds have been the traditional routes for investors
- Now, avoid paying capital gains tax by investing in a fund-of-funds that invests in start-ups
- You can also enjoy this benefit by buying a majority stake in a start-up
- Both these are high-risk options where the payoffs can also be very high