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Parliament has dealt a blow to India's growing debt market. While passing the budget, it has brought in an amendment to the Finance Bill that strips debt mutual funds of a tax benefit they have enjoyed. 

A debt mutual fund is a mutual fund in which the allocation to equity is not more than 35%. The returns of shareholders who stay invested in such funds for at least three years will no longer be treated as long-term capital gains, eligible for a lower tax rate than the investor’s marginal tax rate.

This means debt mutual funds are now at par with bank fixed deposits from a tax standpoint. Until now, they were preferable to bank fixed deposits if left untouched for at least three years, as long term capital gains were taxed at 20% with the benefit of indexation, or 10% without indexation.

Indexation is a process of recalibrating the original investment value to take into account inflation since the time of the investment. This reduced the capital gain on which tax has to be paid. 

The income tax department provides the indexation table, in which the price level in 2001-02 is treated as 100. Say you had invested 100,000 in a debt mutual fund in 2017-18 and redeemed it in 2022-23. The index for 2017-18 is 272 and the index for 2022-23 is 331. The inflation-adjusted value of your 100,000 in 2022-23 is thus 331/272 x 100,000 or 121,691.2. The capital gain is calculated as if the original investment was 121,691.

Now, this benefit has been removed for debt mutual funds for investments made after April 1.

This primarily affects companies, which have been the biggest users of this asset class, using it to lower their tax outgo. Firms with cash left over after paying dividends, taxes and other expenses, have to store it somewhere. Since holding some cash gives them the flexibility of moving quickly when they see an investment opportunity, they hold sizeable amounts of it on their books instead of returning it to shareholders immediately. 

Debt mutual funds have proved a useful asset for storing such corporate surpluses since they are reasonably liquid, offer decent returns and – until now – offered a concessional rate of tax if held for at least three years.

But the government has decided it can ill-afford to give such a tax concession to rich companies and has withdrawn the tax shelter. Companies lose out and banks gain – somewhat.

During the low-rate regime that ended only a year ago, fixed deposits lost their sheen in the eyes of the middle-class saver. These offered such low rates of return that savers began to explore new avenues of investment such as mutual funds and equity-linked saving schemes. 

Banks did not do much lending either and did not face a crunch because of the reduced inflow of deposits. But if banks are to start lending again, they need deposits. Debt mutual funds, with their concessional tax treatment, were an attractive alternative to bank deposits. You cannot blame the banks for hoping for an end to this deposit-killing tax benefit of debt mutual funds.

Now the government has granted banks their wish and given itself a tax boost. Of course, companies with large reserves will see their tax bill increase. This move will also hit the corporate debt market hard, and even successful debt bundles such as Bharat Bond will find fewer takers.

A vibrant bond market is essential for financing projects with long gestation periods. Banks are ideal for short-duration credit: their liabilities, primarily their deposits, have short maturities and need to be invested – ideally – in assets with similar maturities. Bonds on the other hand can have long tenures and also enable arms-length financing.

When a project is funded by bonds, costs are examined by any number of analysts, brokerages, and busybodies like Hindenburg. When only bank loans are involved, a few bankers take a call on the viability of the project, the reasonable cost, and so on.

A bond market can no doubt develop without tax breaks but will take much longer to do so. And bond markets thrive when the risks associated with investment in bonds – on exchange rates and interest rates – are freely hedged through derivatives. But the government has, in the latest budget, sharply increased the securities transactions tax (STT) on futures and options, further hindering the hedging of risk in the bond market and stunting its growth.

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Updated: 24 Mar 2023, 04:08 PM IST
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