Deferral of Taxes

Deferral of Taxes

Deferral of Taxes

Small Drops Make the Ocean- Insignificant Postponement of Tax Incidence Adds Significant Wealth Over Time.

Warren Buffet released his much-awaited annual letter to shareholders a couple of weeks back. One of the points from the letter that is simple to understand and can be easily implemented is deferred taxes.

The amount of gains that an investor can make, seem very modest and immaterial at the beginning; however, the amounts can snowball into very material sums over longer periods.

To further elaborate on this, lets to go through this in detail.

1. Excerpts from Warren Buffets letter 2018

“The final funding source – which again Berkshire possesses to an unusual degree – is deferred income taxes.

These are liabilities that we will eventually pay but that are meanwhile interest-free.

As I indicated earlier, about $14.7 billion of our $50.5 billion of deferred taxes arises from the unrealized gains in our equity holdings.

These liabilities are accrued in our financial statements at the current 21% corporate tax rate but will be paid at the rates prevailing when our investments are sold.

Between now and then, we in effect have an interest-free “loan” that allows us to have more money working for us in equities than would otherwise be the case.”

2. In simpler words, in case taxes are moved into the future instead of an immediate payment the resultant impact will be an interest free loan that lies with the investor till payment.
In case the loan is invested and earns interest the resultant income would accrue to the investor.
3. Multiple questions that arises from the above which has built on a question and answer
Yes. As mutual fund investments gains attract tax only at the time of sale one can easily push the tax into the future by letting the investments in open ended funds continue as long as possible.

Yes. This is meaningful due to the tax deferral.

To illustrate this, would like to show how the same impacts debt products as the tax on debt instruments such as deposits or interest paying securities is 30% and has to be paid each year.

The following table provides a snapshot of how the numbers play out as we increase time horizons

The above working has used constant rate of 8% of gains and 30% tax on both the products to show the gains that arise out of deferring the tax liability.

In this table one can see how the deferred tax liability moves up from 2.4 to 34 in 10 years and 109 in 20 years. The progressive snowball is very large over longer periods of time.

One can also see the difference in net worth due to deferring the taxes v/s paying the same immediately. The net worth is higher by 5% in a 10- year period and 20 % over a 20 -year period.

One also needs to be mindful that the absolute amounts can be very significant given the %ages are that of the very high end values .

Debt Mutual Funds are the biggest area of opportunity as the gains are multi fold. Besides the tax liability getting deferred one gets a lower rate of taxation in debt funds.

The long- term tax rate on debt funds are 20 % post indexation which is estimated to be 10% -12% effective rate of tax as against the 30% tax on interest income

The table below shows how the same works out over longer periods of time

In this case the gains accrue on both the tax rate as well as tax deferral. One can see the %age net worth is higher by 17% in year 10 and 42% in year 20.

The absolute gain over a Rs 100 invested in the beginning is Rs 172 in year 10 and Rs 297 in year 20 which is quite significant.

Yes. the principle works in all cases. However, the gains will be significant only over longer horizons. To make things simple tax rate is taken as 10% for both debt and equity investments.

In this case one can see the difference in net worth is 2% in 10- Years and 7% over a 20- year period. The absolute numbers is Rs 4 for every 100 invested at the end of 10 years and 28 for every Rs 100 invested at the end of 20 years.

The key variables impact this significantly i.e. the tax rates and the holding tenure to ensure that the benefits snowball into meaningful amounts. Also, one cannot generalise the rule on every avenue. For example, Insurance advisors use this principle (Longer tenures and zero taxes) to illustrate better results. However, illiquidity induced in the nature of the products and higher upfront costs loaded has resulted in not the best outcomes.

Yes. These are primarily to ensure increased tenure of holdings

1. Well defined objectives while structuring of portfolios to ensure longer shelf life

2. Structure the portfolio into Core/ Strategic and Non- Core/ Tactical to ensure there is limited rebalancing.

Select products that have a long shelf life where the investment objectives are unlikely to change and match with what is desired from the portfolio. (eg. Index Allocations, High Credit quality debt funds, clearly defining on risk tolerance in allocations, factoring in net yield post delinquencies for credit funds, risk versus rewards analysis etc).

1. Ensure the costs to the product are reasonable.

2. Traditional funds have a significant longer shelf life when compared to the flavour of the season investing.

4. Summary Snippets

1. There is no quick fix solution to building longer term wealth or retirement corpus

2. Easier working on the ones and twos compared to work on the sixes all the time

Small amounts can snowball into significantly large numbers over longer periods of time as can be seen in the very small deferred tax number growing to a significantly large number. This can be seen in the deferred tax liability of Berkshire amounting to $14.7 bn on equity gains that have accrued over time.

4. Disclaimer

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The information herein is derived from publicly available sources that Trufid considers reliable but which has not been independently verified.

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Expressions of opinion are those of Trufid only and are subject to change without notice.

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