While the public at large seems to be confused about what to make of the budget, investors in debt mutual funds would surely give it a thumbs-down. This is because of a seemingly “slight” change in the tax treatment of debt funds proposed in the budget.
Existing tax regime for debt mutual funds
Debt mutual funds invest in fixed income instruments like, government or corporate bonds, money market instruments, etc. Some of these funds are similar to bank fixed deposits in terms of risk.
However, they are able to provide better returns to investors because of the tax treatment accorded to such funds. Currently, any gains arising from the growth option of debt funds held for over 1 year are considered as long term capital gain and taxed at lower of (a) 10% without indexation and (b) 20% with indexation. Therefore, for an investor falling in the 30% tax bracket, debt funds provide a straight, after tax benefit of at least 3% over bank fixed deposits.
What the Finance Bill proposes
The Finance Minister seeks to eliminate the above advantage by increasing the holding period to 3 years for qualifying as a long term capital asset. Therefore, any investments in debt funds which are redeemed before 3 years would now be taxed as short term capital gains and liable to tax at the applicable slab rate for individual investors. Further, even if investors hold on for more than 3 years, they will no longer have the option of paying tax at the lower rate of 10% (without indexation).
Accordingly, the higher returns enjoyed by these debt funds over bank FDs will likely be eliminated.
How this amendment adversely affects the retail investor
The reason given for introducing the amendment is that debt funds are used more by corporates instead of retail investors for whom the benefits were meant.
It is true that majority of the investments in debt mutual funds was being done by corporates, but, one has to understand that the mutual fund industry is at a nascent stage in India. It will take time for debt funds to penetrate into the retail market as most investors currently do not understand the nuances of debt fund investments. This is also evident from the fact that retail participation in these funds has been gradually increasing because of growing awareness in the last few years.
Some people will argue that one can still take the benefit by holding onto these funds for more than 3 years. However, they are forgetting that these funds are extensively used by retail investors for short term planning of less than 3 years.
Inflation, the real money killer
The reduction in returns is a body blow to retail investors especially considering the heavy burden imposed by inflation on an investor’s real returns. Since the advantage offered by debt funds would now be eliminated in short term, investors would have negative returns, in real terms. The tax benefit at least allowed an investor to protect his capital from inflation to a certain extent.
No retrospective amendments… think again
Surprisingly, this amendment is proposed to take effect for all investments redeemed after 1April 2014. Therefore, investors who have already redeemed their1 year old investments in the current financial year will be heavily penalised because these redemptions will be considered as short term capital gains. Further, anyone who has already invested for FY 2014-15 with a 1-2 year horizon, will now have to redraw his plans or suffer higher tax burden than what was envisaged.
The icing on the cake
The biggest anomaly in all of this is that underlying instruments in which these debt funds invest such as, government bonds, listed debentures, etc. continue to enjoy the 1 year threshold to qualify as long term capital assets. Therefore, if an investor directly purchases these instruments from the stock market and sells them after 1 year, the gains will be classified as long term capital gains whereas if he buys units in a debt mutual fund and sells them after 1 year (but before the completion of 3 years), the gains are taxed as short term capital gains.
Debt markets are highly complex and retail investors do not possess the expertise to invest directly in these markets. Debt funds provided expertise and a professionally managed vehicle for retail investors to generate stable returns in a cost effective manner. The Finance Minister in a single move has signaled the death of these funds.