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Who qualify as an HNIs in India?
High Net-worth Individuals or HNIs, include those individuals who have investable assets of more than 5 Cr INR. The flourishing business environment in India, surge in the number of digital entrepreneurs, and foreign investments has facilitated the growth of the number of HNIs in the country. Currently, there are around 3 lakh HNIs in India, and the number is expected to reach 9.5 lakhs by the year 2027. They contribute about 58% to India’s GDP. Almost 30% of the Indian HNI population belong to metro cities of Delhi and Mumbai.
With huge amounts of investible money, HNIs are exposed to high rates of taxation. With the changes in the tax brackets according to the Budget 2019, there has been a steep rise of 22% in the surcharge rates for taxable income of more than 5 Cr INR. As a result, the effective rate of taxation for HNIs is as high as 42.74%. This forces HNIs to look for alternate ways of investments. Through this article we will look at how they can invest their money through tax efficient strategies.
Mistakes that most HNIs make
- Neglecting surcharge while paying advance tax — Most HNIs and Ultra HNIs who have income of more than 1 Cr INR and are liable to pay 1% surcharge while paying the advance tax often forget to do so. This results in them paying an additional simple interest penalty of 1% p.m. on quarterly shortfall.
- Short term trading and F&O transactions — As a result of their short sightedness, HNIs often engage in short term trading or deal with Futures and Options (F&O). Hence they have to pay a tax of 15% on short term equity trading, while the latter is liable for a maximum 30% rate of taxation. In case the margin on transaction exceeds 1 Cr INR p.a, a proper book of accounts and audit needs to be carried out before filing the tax returns.
- Untapped opportunities of saving tax on long term capital gain — Contrary to general assumption, LTCG exemptions are applicable not only on the sale proceeds of residential property but also on other asset classes like gold, shares of unlisted companies, units of AIFs, commercial properties, etc. HNIs having huge holdings of these asset classes can invest the sale proceeds in property or specified bonds, which would save them 20% of tax on capital gains.
- Not availing complete deductions benefits — While deductions under Section 80C provide only nominal reduction in tax liabilities for HNIs, they should also focus on other areas which can provide them some tax relief. These include mediclaim, education loan, National Pension Scheme.
Saving taxes by creating separate legal entities for HNIs — HUFs, Trusts and its advantages
One of the ways of saving taxes on investments is by creating a pool of assets or a family unit by forming an HUF. It usually consists of assets that are received as part of a gift, will, or an ancestral property. HUFs and its members can claim deductions as stated under Section 80C, while filing their tax returns. As a separate entity, HUF enjoys a threshold exemption of 2.5 lacs INR and is taxed at individual slab rates thereafter. It can also avail separate deductions under Section-80C upto 1.5 lacs INR, Mediclaim for family members under Section-80D up to INR 25,000 and in case any member is a senior citizen up to INR 50,000, under Section-80TTA up to INR 10,000 and for senior citizens up to INR 50,000. Moreover, capital gains exemptions can also be claimed by an HUF under Section 54 and section 54F, 54B, 54EC, of Income tax Act,1961.
While forming an HUF or a family trust has several investment and tax-saving advantages, it can be quite difficult to dissolve since it requires equal consent of all the members.
Another option for HNIs to reduce their tax burden is to form a Limited Liability Partnership (LLP). Partners can infuse capital in several ways and firms can even raise funds from banks, corporates and NBFCs as well. The effective rate of taxation on LLPs is about 35%, which is lower than the effective tax rate of about 43% applicable to HNIs.
Engage investments in tax-efficient products
Apart from creating an HUF trust, there are some other ways in which HNIs can save their money on taxes.
- Market Linked Debentures (MLDs) — As the name suggests, these debt securities are linked to the market performance. Issued by NBFCs, these bonds have payouts linked to the equity markets. If they are held for a period for more than one year, only 10% LTCG is charged on the interest earned, irrespective of the income slab of the investor. Thus, making it tax efficient. Industry experts suggest that those investors that come under the 30% bracket should invest in MLDs as they can gain the most.
- Tax free bonds — HNIs may also choose to invest their money in bonds, such as those issued by Hudco, NHAI, Ireda, etc. Investors are not required to pay any tax on its returns as per Section 10 of the Income Tax Act. Compared to bank FDs, these bonds offer a better tax-efficient return to those who fall in the highest income tax brackets. However, these bonds generally carry a maturity of ten years or more.
- REITs and InVITS — Real Estate Investment Trusts (REITs) invest in commercial real estate, whereas Infrastructure Investment Trusts (InVITs) invests in infrastructure projects. These trusts are profitable as they are mandatorily required to pay 90% of their distributed cash flow and can have high dividend yields. Dividends earned from these securities are tax free for the investors. However, the investors may be subject to capital gains tax of 15% if the holding period is less than 3 years, and of 10% if holding period exceeds 3 years.
Acceptance among professionals for tax saving instruments
While some investment professionals may suggest the above measures to their HNI clients, others have a mixed opinion regarding the same.
Entrepreneurs and professionals welcome the LLP structure not only because they are tax efficient but also provide increased efficiency. While MLDs and direct purchase of bonds may be tax efficient, they may carry some degree of issuer risk. Thus, investors must be careful before investing in these options. High-yielding but low rated investments face immense liquidity risks. Some investment professionals advise to avoid concentration in investments in the AA-rated and below-AA-rated segment until the economy revives from the downturn. Therefore, higher returns should not be the only criteria for investments, equal importance should be given to the risk factor involved.
Importance of portfolio rebalancing and goal setting
Traditionally, HNIs focussed on investing in a mix of debt and equity. However, there has been a shift towards other investment classes over the years that match the cash flows with liquidity and inflation. With greater amounts of wealth available, HNIs have a wide range of opportunities available for investment. However, there are certain points that should be considered while investing their funds. While choosing the asset classes to invest in, one should focus on diversification along with portfolio rebalancing. It is advisable that investors should put little weightage on complicated asset classes, as they come with liquidity constraints. Moreover, it is important that HNIs set a goal for their funds, and stay focussed till the goal is achieved.
In order to save themselves from high rates of taxation, HNIs should plan and look at the big picture before undertaking an investment. With the right investment strategy and the help of financial advisors, HNIs can find the most efficient investment options that fulfill their needs and will also help them take the benefit of untapped opportunities.
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This article has been co-authored by Tamanna Kapur, who is in the Research and Insights team of Torre Capital.