Case 068Rebalancing and driftHard

A household holds its equity mostly in the father's name at an illustrative 30% slab and its debt mostly in the family HUF at a lower slab, with the target set for the household. Rebalance Rs 6 crore from 70/30 to 60/40 at the lowest tax cost.

The situation

The Bhagwat household manages Rs 6 crore across three accounts to one household target. The father, taxed at an illustrative 30% marginal slab, holds Rs 2.6 crore of equity, half of it unrealised gain, and Rs 20 lakh of debt. The mother, at an illustrative 20%, holds Rs 80 lakh of equity with gains of 20% of value and Rs 40 lakh of debt. The family HUF, at an illustrative 10%, holds Rs 80 lakh of equity with gains of 10% of value and Rs 1.2 crore of debt.

The household is at 70/30 and the committee wants 60/40. For this case, tax equity gains at a flat illustrative 12.5% whoever sells, and debt interest at the holder's slab; assume new debt yields 7.5%. Each account's money stays in that account; moving money between them raises gift and clubbing questions to be confirmed separately.

Your task

Where should the switch from equity to debt be placed, and how much tax does the placement save?

Quick check

Equity gains are taxed at the same flat rate for everyone. Does it matter whose equity is sold?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

Place the whole Rs 60 lakh switch in the HUF: sell its equity, which carries the smallest gain share, and buy debt there, where interest is taxed at the lowest slab. The sale costs Rs 0.75 lakh of tax against Rs 3.75 lakh in the father's account, and the new debt income is taxed at 10% instead of 30%. Over five years that placement costs Rs 3.00 lakh, against Rs 8.21 lakh pro rata and Rs 10.50 lakh in the father's name.

Step 1Why rebalance the household rather than each account?

A family with three kitchens and one grocery list does not buy the same vegetables for each kitchen; it buys what the household needs and stores it where it keeps best. The target is set for the household, so only the household mix has to reach 60/40; each account can be as lopsided as tax efficiency requires. The household holds Rs 4.2 crore of equity; at 60% of Rs 6 crore it should hold Rs 3.6 crore, so Rs 60 lakh moves from equity to debt.

Step 2Where does selling equity cost the least tax?

With a flat rate on gains, the tax depends on how much of each rupee sold is gain. Rs 60 lakh sold in the HUF realises Rs 6 lakh of gain and Rs 0.75 lakh of tax; in the father's account it realises Rs 30 lakh and Rs 3.75 lakh of tax. The HUF holds Rs 80 lakh of equity, enough to carry the whole sale.

Step 3Where should the new debt sit?

Debt interest is taxed at the holder's slab, so it belongs where the slab is lowest. Rs 60 lakh at 7.5% earns Rs 4.5 lakh a year, taxed at Rs 0.45 lakh in the HUF against Rs 1.35 lakh in the father's name. Conveniently the cheapest place to sell equity and the cheapest place to hold debt are the same account, so the trade never has to move money between accounts, which avoids gift and clubbingRules under which income from money given to a spouse or minor child is added back to the giver's income for tax. questions entirely.

Place the whole Rs 0.6 crore switch where it costs least tax: the HUFFatherSlab, illustrative30%Equity, Rs cr2.6Gain share of equity50%Debt, Rs cr0.2No trade hereMotherSlab, illustrative20%Equity, Rs cr0.8Gain share of equity20%Debt, Rs cr0.4No trade hereFamily HUFSlab, illustrative10%Equity, Rs cr0.8Gain share of equity10%Debt, Rs cr1.2Sell equity 0.6Buy debt 0.6Household before: equity 4.2, debt 1.8 of 6.0 crore = 70/30Household after: equity 3.6, debt 2.4 of 6.0 crore = 60/40
The HUF has both the smallest gain share on its equity, 10%, and the lowest illustrative slab, 10%, so selling Rs 60 lakh of equity and buying Rs 60 lakh of debt there takes the household from 70/30 to 60/40 at the lowest tax cost.
PlacementTax on sale, Rs lakhTax on new debt a yearFive-year total
HUF only0.750.453.00
Pro rata2.751.098.21
Father only3.751.3510.50
Placing the switch in the HUF costs Rs 3.00 lakh of tax over five years, against Rs 8.21 lakh if every account trades its share and Rs 10.50 lakh if the father's account does it all.
Same household trade, three placements: tax over five years (Rs lakh)HUF only3.00Pro rata8.21Father only10.50tax on the equity salefive years of tax on new debt incomePlacing it in the HUF saves Rs 7.5 lakh against the father's account over five years.
Over five years the same 70/30 to 60/40 switch costs Rs 3.00 lakh of tax placed in the HUF, Rs 8.21 lakh spread pro rata and Rs 10.50 lakh placed in the father's account.

State the costs of the tidy answer. After the trade the HUF holds only Rs 20 lakh of equity, so the household's equity is concentrated in the father's name, where any future equity sale is expensive; the next rebalance in the other direction should buy equity in the HUF or the mother's account. The slabs are illustrative and depend on each holder's other income, and HUF rules on who can deal and how income is shared should be confirmed. The principle survives the details: rebalance the household in the account where the trade costs least tax.

Where candidates lose it

The common error is rebalancing each account to 60/40, which sells the father's heavily-gained equity and parks new debt at his 30% slab: about Rs 10 lakh of tax over five years for a trade that can cost Rs 3 lakh.

The second miss is saying the equity rate is flat, so it does not matter where you sell. The rate is flat; the gain share is not.

What the interviewer asks next

  • The HUF held only Rs 30 lakh of equity. How would you place the rest of the trade?
  • Markets fall and the household must go back to 70/30. Where do you buy?
  • How would the answer change if equity gains were taxed at each holder's slab?

Company names and figures are illustrative.