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Bond fund tax increase will have marginal impact, except on FMP investors

The hike in long-term capital gains on debt funds will have a limited impact, except on some FMP investors

Since yesterday, coverage of mutual fund investments vis-a-vis Budget 2014 across most mass media has been dominated by the changes in taxation on bond funds. However, some Value Research readers are puzzled that we haven’t given it much importance. The reason is simple. Although these changes sound like a big deal, they will affect relatively few investors. Moreover, as Mr. Jaitley himself pointed out in his speech, their effect will be limited almost entirely to corporate investors. We don’t think these changes are a big deal for the individual investor.

The most severely affected will be those who have existing investments in FMPs of periods greater than one year but less than three years.

To understand the impact, let’s first look at what the Finance Minister actually said:

In the case of Mutual Funds, other than equity oriented funds, the capital gains arising on transfer of units held for more than a year is taxed at a concessional rate of 10% whereas direct investments in banks and other debt instruments attract a higher rate of tax. This allows tax arbitrage opportunity. This arbitrage has hardly benefited retail investors as their percentage is very small among such Mutual Fund investors. With a view to remove this tax arbitrage, I propose to increase the rate of tax on long term capital gains from 10 percent to 20 percent on transfer of units of such funds. I also propose to increase the period of holding in respect of such units from 12 months to 36 months for this purpose.

Here’s what the impact will be:

  1. Almost all bond fund investments are made for periods of less than one year. These returns were already short-term capital gains. Since receiving returns in the form of dividends creates a lower tax liability, such investments were mostly in dividend plans. In bond funds, these plans generate no capital gains so there is no impact.
  2. A retail-oriented category of mutual fund that will be affected are MIPs and other debt-oriented hybrid funds. Investments in these are generally for more than three years. The tax outgo on the returns of these funds are calculated after cost-indexing, which generally leaves very small taxable returns. The net rupee effect of the tax increase is likely marginal.
  3. The largest impact will come in FMPs (fixed maturity plans). These will still be more tax efficient than bank fixed deposits but will have to be held for three years to realise the benefits. The cost-indexation factor will apply to the same degree as MIPs (see above). The class investors who will be really caught out are those who have existing investments of greater than one year and less than three years. When their redemption comes, the returns will be treated as short-term instead of long-term capital gains.