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Debt Funds May Lose their Tax Arbitrage

Hiking tax rates on debt funds may prompt corporates & short-term investors to reconsider them

Managers of debt mutual funds are probably not sure whether to laugh or to cry at Finance Minister Jaitley's twin salvos in the budget. On one hand, the Finance Minister's decision to stick to a fiscal deficit target of 4.1 per cent and his frugal and expenditure-conscious budget is reason to cheer, for all of them. With this, the Finance Minister has paved the way for interest rates to fall, bond prices to rise and for bullish sentiment in the bond markets to continue. This should help income funds and gilt funds pocket neat gains from duration calls and deliver healthy returns over the next year or so.

But the budget has also dealt a body blow to short term investors in debt funds, by sharply hiking the taxes that they pay on money invested for less than 3 years. Budget proposals that affect debt mutual funds are twofold. One, the Finance Minister seeks to change the definition of 'long term' for debt mutual funds from the present 12 months to 36 months. Once this takes effect, the returns that investors earn on debt funds in the first 36 months will be treated as 'short term' capital gains. This will be clubbed with the investor's income and taxed at his income tax rate. This is contrast to the earlier rule, where only investments held for less than 12 months were 'short term'. As a result of this move, investors who redeem debt fund units within 1-3 years will end up paying a tax of 10-30 per cent on their returns, instead of the 10 per cent they pay now. Product categories such as 366-day FMPs and liquid funds may suffer a big setback if these proposals take effect.

Two, the budget also seeks to remove the concessional tax rate of 10 per cent on long-term capital gains made from debt funds. Instead, the long term gains on these funds (held for 3 years), will now be taxed at 20 per cent, after adjusting for indexation. However, this is not a material negative for investors, as during highly inflationary periods, the indexation will automatically reduce taxes to a marginal amount. Debt funds therefore will still remain quite attractive for all categories of investors, including corporates, who are willing to park money for 3 years or more.

No tax arbitrage
If these proposals take effect, they will do away with significant tax arbitrage that debt mutual funds enjoy over alternative avenues such as bank deposits, for short term investors. This may prompt corporates, who contribute 81 per cent of the assets in liquid funds and 58 per cent of the money in other debt funds, to reconsider their investments. One to three year Fixed Maturity Plans (FMPs) may lose their allure too, with their gains now likely to attract capital gains tax at 10-30 per cent.

Hopeful of change
However, the industry is hopeful of presenting its case to the Finance Minister to make the new provisions applicable only to FMPs, rather than all open end debt funds. “Apart from the industry impact, the move to increase short term capital gains tax on debt funds may impact the market itself, because mutual funds have been a key source of 1 to 3-year money to corporates and the government in the debt market. Given the need to deepen and improve liquidity in the bond market, we are planning to represent to the government that the new provisions be made applicable to Fixed Maturity Plans alone and not to other open end debt funds. In fact, this is what the Urjit Patel Committee also recommended”, says A Balasubramanian, CEO of Birla Sun Life Mutual Fund.

Whether or not the proposals are reviewed, the industry should take heart from the fact that these changes can have positive spinoffs over the long term. For one, with the tax arbitrage on short term funds gone, investors may be prompted to take a more long-term view of their debt fund investments and park more than 3 year money in debt mutual funds instead of using them as a temporary vehicle. This would mean less churn in debt assets for the industry.

Two, with the tax advantage gone, debt funds will have to generate genuinely superior returns to attract investors, rather than leaning on the crutch of tax breaks. Fund houses who manage to do this may benefit. Three, less focus on the high-churn corporate money which finds its way into liquid funds and greater focus on long term investors, may help the fund industry build the debt side of the business on a more robust foundation.

Therefore the Finance Minister may have given the debt funds a reason to smile after all.