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Definition: Tax Drag
Tax drag is basically the difference in the return that the investor may get after investing in a tax free security as compared to the ones which have taxes applied on them. Tax drag is something which can potentially reduce the income on any investment drastically. The effect of taxes is very huge on the portfolio investment of HNI’s or other big ticket investors such as various financial institutions operating all around the world.
For Example: There is an investor who wants to invest Rs 10, 00,000 in any of the securities. Let us assume that there are two securities A and B each of them giving a dividend yield of 3.5%. But there is a difference in taxes which needs to be paid on both of securities. If security A charges a withholding tax of 5% while B charges a tax of 15%. Then security A will pay Rs. 35000 less 1750 as taxes, hence net amount received by investor will be Rs 33250 while security B will pay Rs 35000 less Rs.10650 as taxes, hence net amount received will be Rs.44350. Now, the difference between the net amount received by the investor from investing in two securities A and B i.e. Rs. 11100 is known as tax drag.
In order to sustain huge capital gains from the portfolio investments or during transfer of wealth from one country to another or during the transfer of funds by the subsidiary company operating in one country to its parent company operating in some other country, it is very necessary to consider the effect of tax drag on the income received from investing in various securities as well as in various countries.