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Longer holding, higher tax takes sheen off debt funds

Investments made for under 36 months termed short-term.

Written by Sandeep Singh | New Delhi | Published:July 14, 2014 2:19 am

The Budget announcements of a higher capital gains tax for debt schemes of mutual funds and increasing the holding period is set to impact investors who typically invest in these schemes eyeing the relatively higher post-tax returns.

The long-term capital gains tax on debt schemes of mutual funds has been hiked to 20 per cent, and the minimum holding period raised to 36 months from 12 months in order to claim the benefit of long-term capital gains.

On Saturday, revenue secretary Shaktikanta Das suggested that the new tax rates may not be applicable for units redeemed before the Budget announcement on July 10, 2014 as against reports suggesting that all redemptions beginning April 1, 2014 would be taxed at the new rates.

Experts, however, feel that the decision is retrospective and all fresh redemptions of schemes purchased and held for less than 36 months will be treated as short-term gain and taxed at the marginal rate.

Earlier, long-term capital gains in debt schemes were taxed at 10 per cent (without indexation) and at 20 per cent (with indeaxation).  Financial advisors and mutual fund players say investors have been flooding them with queries on the Budget proposals.

Industry insiders feel the decision to raise the minimum holding period takes away the attractiveness of the scheme since majority of the debt investment was made for 12-18 months where investors could get double indexation benefits being long-term in nature. “This will have a big impact as majority (over 85 per cent) of the debt investments were done for 12-18 months. Dividend money was invested into it by HNIs and even corporates who had held back their capex plans were investing in debt products of 12-18 months because of the tax arbitrage.

“Now all that money will get taxed at marginal tax rate generating higher revenue for the government. Only retail investors invested in products of 36 months and above stand to gain,” said the chief investment officer of a leading mutual fund requesting anonymity.

As on June 30, the assets under management (AUM) in close-ended income funds stood at Rs 1,73,967 crore, most of which will get directly impacted by the decision.

Even open-ended income funds which have an AUM of Rs 2,94,792 crore will get affected as most of the investments are less than 36 months. So an aggregate AUM of up to Rs 4,78,982 may be taxed at a higher rate going forward.

By this move, the government has taken away the option for short-term investors as there is no tax arbitrage vis-à-vis bank fixed deposits. In the long-term (36 months and above) though investors will continue to benefit by investing in debt schemes as against fixed deposits as the capital gains will be taxed at 20 per cent.

“There is, however, no clarity on whether the indexation benefit will continue or not,” said the CIO. If the indexation benefit is permitted then investors will continue to benefit significantly by investing for over three years especially if the interest rates and inflation continue to rule high.

“The real dampener is change in the nature of treatment for long term tax benefits. Removing the option of 10 per cent tax rate (without indexation) will not impact much as most of the investors go for 20 per cent tax rate (with indexation) option. Now they will have to remain invested for 36 months,” said Vishal Dhawan, CFP and founder director of Plan Ahead Wealth Advisors.

Say an investor invests Rs 100 in a debt scheme for over three years, generating a return of 9 per cent per annum with inflation at 7 per cent. After three years while the investment would have grown to Rs 129.5, the indexed value of Rs 100 would have risen to Rs 122.5. This means the long-term capital gains would be calculated on the difference i.e. Rs 7. A 20 per cent tax on this would amount to Rs 1.4.
Even if the indexation benefit is removed from long-term tax rate, 20 per cent is still a more attractive tax rate for those falling in the highest tax bracket of 30 per cent.

Industry players feel that the move will lead to product manufacturers going in for developing and promoting long-term debt products.
So what options do investors have?

While fixed maturity plans that are close-ended debt products, do not leave investors with any option but to face higher tax, experts feel that open-ended debt products can lead to higher tax savings. “If one is invested in open-ended debt schemes and can hold on the investment for three years then one can save on taxes as it would qualify for long term capital gains which attracts lower taxation,” said Surya Bhatia, a Delhi-based financial planner.

Dhawan advises that with changing nature of taxation and their retrospective implementation by the government, investors going forward should look to invest in open-ended schemes that offer greater flexibility.

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