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Four Ways to Untangle the Debt Fund Mess

The solutions to the debt mutual fund problem are not that complicated. Here are four fixes that can help the FM raise taxes from debt mutual funds, without an adverse impact on retail investors

After proposing an inequitable and back-dated tax on debt mutual fund investors in the budget, the government has now promised a rethink. We still don't know what shape the proposals will take or even how long the government will take to put them into effect. But here are four simple fixes to the problem, that will allow the FM to levy some tax and yet protect the interests of retail investors.

  • Keep open end debt funds out of the proposals: There seems to be just one motivation behind the complicated budget proposals to lengthen the definition of 'short term' for all debt funds and to increase long term capital gains tax on them - to protect the government's blue-eyed boys - the banks. FMPs were seen to be competing directly with bank fixed deposits for 1-3 years with their indexed capital gains benefits, thus prompting the FM to remove this 'tax arbitrage'. Yes, close ended FMPs, where investors lock in money for a 1-3 year period for a fixed yield can be said to be competing with banks. But why penalise other open end debt mutual funds, which are hardly the same asset class as bank deposits? Open end debt funds, after all, hardly attract the same kind of investors as bank FDs. If bank FDs offer 100 per cent safety and an assured return to investors who are willing to lock in money, open debt funds do precisely the opposite. They offer fluctuating market-linked returns with anytime liquidity. Thus, they are used as treasury management vehicles by high-income investors and companies. Given their market-linked nature, these funds need to be very actively managed, making constant trade-offs on credit, interest rates and liquidity to deliver this balance of returns and liquidity to investors. Banks, in any case, are not going to attempt active treasury management. So why worry about debt mutual funds competing with them? Even the Urjit Patel Committee, which seems to be the basis for the budget changes, mentioned only FMPs and not open end debt funds as enjoying a tax advantage over banks.
  • Make the proposals effective July 10: There has been much debate about whether the budget proposals, by seeking to tax investors who have already put money in FMPs and debt funds, is retrospective or retroactive. The terminology is immaterial. Changing the tax structure on a close ended instrument which investors bought because it enjoyed certain tax concessions at the time of purchase, is clearly inequitable. Therefore, without over-thinking the issue, it would be best to make the new provisions applicable only to FMPs launched after July 10, the budget date. This is when the government informed investors of its tax changes on debt funds. Therefore, only investors who buy FMPs after this date should be impacted by the new rules.
  • Differentiate between retail and institutional investors: Defending this move, government officials have made the point that debt mutual funds are favoured mainly by companies and institutional investors who can afford to pay more tax. But this is to ignore that retail investors have also invested in debt mutual funds and FMPs. Their assets are not large, but their numbers certainly are. After all, the growing popularity of debt funds with retail investors fits in with the government's objective of promoting financial savings too. If the government is keen to plug the tax arbitrage between funds and banks, why not impose higher capital gains tax on institutional investors alone? Differential tax treatment of retail and corporate investors is not new to the fund industry. Earlier dividends distributed by liquid funds to individual and corporate investors were taxed at different rates. So, while tweaking the rules, why not tax short term capital gains for retail and corporate investors also at different rates? This way, the government can tax corporates who contribute to a big chunk of debt fund assets, while encouraging retail investors to opt for debt funds.
  • Roll over previous FMPs: Even as the government ponders over these proposals, fund houses who are in the process of launching FMPs and those who have FMPs from the last two years coming up for redemption over the next few weeks, would still be in a dilemma. Instead of allowing their investors to wait it out in limbo, these fund houses can offer their existing FMP investors an additional option. Where 1-3 year FMPs are coming up for redemption now, the fund houses can give investors an option to roll over or extend their investments further, so that their holding period is at least three years. This will allow such investors to at least avail of the 20 per cent long term capital gains tax, with indexation benefits, when they redeem units.

Not all investors may be able to stick on, as they may have planned for cash flows from the redemption. But investors who can stay on can at least reduce the impact of this unfair tax on their returns.