A big shift in debt fund taxation has ended ‘revdis’ for India’s rich

Currently, if an investment in a debt MF is redeemed after more than three years, a 20% tax needs to be paid on the gains after taking inflation during this period into account (technically referred to as ‘indexation’). Hence, the actual tax rate is lower than 20%.

From 1 April onwards, this benefit will not be available on fresh investments. Gains will be taxed at the marginal rate in which the taxpayer falls, with no indexation benefit for debt MFs.

This benefit ensured that the income tax paid on gains made on investing in debt MFs were lower than the taxes paid on interest earned on fixed deposits (FDs), which are taxed at the marginal rate without any indexation benefit.

This has got mutual fund CEOs, registered investment advisors, chartered accountants and others who cater to HNIs investing in debt MFs out of their closets, protesting vociferously. A slew of reasons has been offered on why this is a bad idea. These range from how our corporate bond market will not develop to the fact that investors investing in debt MFs are taking on greater risk than those investing in FDs. Some carp about the government sneakily introducing this change in the annual finance bill just before it was passed in Parliament and not mentioning it when the budget was presented on 1 February.

What incumbents in this market space have forgotten to tell us is that their basic business pitch, designed to sell debt MFs as FDs with lower taxes, has been busted. Debt MFs are a complicated product and should have never been sold as FDs with lower taxes.

Now, do the reasons offered make sense? In fact, lower taxes on debt MFs have been available up until now and that has still not led to the development of a well-functioning corporate bond market. So, clearly other factors are holding this market back. Also, any decision has consequences and can’t please everyone on all parameters.

Further, it’s true that debt MF investors take on greater risk. In many cases, they don’t even realize it, given the penchant of incumbents to equate debt MFs with FDs. But the point here is that this risk is for the investors to take, not for the government to incentivize.

Also, yes, the government did introduce the taxation change sneakily. It should not have done that. But saying that this was a surprise is wrong. The central government has been gradually chipping away at the lower tax rates that prevail on income earned on investments. Earlier, in the case of debt MFs, the 20% tax with an indexation benefit would kick in if the investment was held for just over one year. There was no tax on gains from selling stocks held for more than one year. Now there’s a tax of 10%. Even dividends received from stocks are taxable.

Also, the entire interest on the second, third, fourth and nth home loan could be deducted while calculating taxable income, as long as a notional rent was assumed as an income. This helped the well-to-do reduce the income tax they paid, given that rental yields were around 2% and home loan interest rates usually higher than 8%. It also incentivized them to keep buying residential property and keep it locked. Now the total amount of home-loan interest that can be deducted is limited to ₹2 lakh per year, irrespective of the number of home loans. So, yes, the government’s move was sneaky, but definitely not a surprise.

Further, another reason offered by incumbents has been that the world over, income earned from wealth is taxed at lower rates. In fact, Warren Buffett wrote a column in The New York Times in August 2011 pointing out that he had paid federal income tax at the rate of 17.4%, whereas the average tax rate of people in his office was 36%. As Buffett wrote: “If you earn money from a job, your percentage will surely exceed mine." He asked the government to stop coddling the super rich. The same argument works in India.

Indeed, the idea is to move towards a more equitable income tax system where regular salaried/non-salaried income and income earned from wealth are taxed in similar ways. Also, it’s worth remembering that such mollycoddling of the rich leads to increased inequality from one generation to another.

So, it’s hardly surprising that Indian HNIs and the financial ecosystem that caters to them have protested loudly. As things prevailed, tax benefits on debt MFs were not available to those who invested in FDs and who were not in a position to take on the greater risk of investing in debt MFs, given their limited wealth.

Indeed, it was a privilege available to the country’s rich. And not surprisingly, as is often the case with those who are privileged, they are the last to realize it. It’s worth remembering what American writer Upton Sinclair once said: “It’s difficult to get a man to understand something, when his salary depends on his not understanding it."

As far as the government is concerned, it seems to have made up its mind on its new tax regime replacing the old one entirely, albeit in a piecemeal and sneaky manner.

Vivek Kaul is the author of ‘Bad Money’