Debt mutual funds are no longer more tax-efficient than bank FDs

3d render of computer keyboard with MUTUAL FUNDS button (istockphoto)
3d render of computer keyboard with MUTUAL FUNDS button (istockphoto)

Summary

Capital gains on investments made after 31 March in debt MFs, to be taxed at investors’ income tax slab rate

Here is why investors may steer clear of debt mutual funds (MFs). Gains from investments in these funds—if held for over three years— were hitherto treated as long-term capital gains (LTCG) and taxed at 20% with indexation benefit. The funds are set to lose this taxation benefit from 1 April, as per one of the amendments in the Finance Bill, which was passed in Lok Sabha on 24 March.

The amendment dictates that investment in MFs with upto 35% equity exposure to domestic companies —essentially debt funds—will now be taxed at the investors’ income tax slab rate.

This brings the taxation treatment for debt funds on par with a bank fixed deposit (FD), where the capital gains are added to the investors income and taxed at their slab rates. Earlier, indexation benefit allowed debt fund investors to inflate their cost of acquisition over their holding period, and book less capital gains.

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Graphic: Mint

So, now an investor, regardless of his or her holding period in such funds will be taxed as per their slab. (Previously, LTCG was applicable after three years). If investors fall in the highest income tax slab, which mandates a tax rate of 30%, then they have to pay 35.8% (including surcharge and cess) on their gains without any indexation benefit.

Industry experts say this would not only impact investor flows into debt funds but also the bond market. “MFs offered liquidity in the domestic bond market, which is otherwise not as liquid. Investor flows coming into debt MFs were deployed into the bond markets," points out Niranjan Avasthi, head, product, marketing and digital business, Edelweiss Asset Management.

“This move not only impacts debt MFs, but also international funds and gold funds," says Kirtan Shah, founder and chief executive of Credence Wealth. The latter fund categories were also treated as debt funds for taxation purpose.

Vikram Dalal, managing director at Synergee Capital Services, says that earlier a target maturity fund, depending on the underlying portfolio, could offer post-tax yield of 7%. “There was a good tax arbitrage in such funds as FD with interest rate of 8% could only offer post-tax return of 5% for those in the highest tax slabs," he says.

Fund houses may be able to come up with some alternative to offer tax benefits by adding arbitrage (equity derivative strategies) in some hybrid funds. For instance, one investment expert said, the equity exposure can be kept at 40% in some hybrid schemes by using equity derivatives exposure. But this would finally depend on whether the market regulator Securities and Exchange Board of India (Sebi) allows such product tweaks or not. Sebi has defined each fund category and the asset allocation framework for each of these fund categories.

Another industry executive said if flows rise in arbitrage strategies (using equity derivatives), the spreads in these strategies could shrink.

Industry executives say this move could impact growth of the MF industry at least in the near term. “Through target maturity funds, the MF industry was just starting to build an investor base with longer tenure investor money. We will have to see how fresh flows in such schemes shape up, going ahead," says Swarup Mohanty, chief executive officer of Mirae MF.

Target maturity funds are passive debt fund schemes that track an underlying index. While these funds are open-end debt schemes, they have a fixed maturity date. It was advisable to stay invested till the maturity of the fund to get close to the yield-to-maturity returns of the underlying index. These funds were starting to find favour among investors looking to park large surpluses over longer tenure. However, these funds just like other debt funds, would lose some of their attractiveness after the tax amendment.

According to people aware of the developments, the Association of Mutual Funds in India is looking to make presentations to government and Sebi to review this move, but it remains to be seen if any changes would be possible.

For existing investors or those who invest in a debt MF before 1 April, there is still a silver lining. Any investment done before this date will still enjoy the LTCG tax rate of 20% with indexation benefit after three years.

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