The Murder of the Debt Mutual Fund By Closing a Tax Loophole

51 comments Written on July 10th, 2014 by
Categories: Budget2014, MutualFunds

 

Invested in an FMP?

Bought a Liquid Fund And Stuck around for a Year?

Bought Debt Funds for the “Inflation Indexation”?

You’re going to hate Arun Jaitley.

 

Let’s start with the basics. You can invest in a fixed deposit with banks. Which pays you interest. The interest is added to your income, and taxed at the highest rate you qualify in. So a 9% fixed deposit falls down to 6.3% if you are in the 30% bracket.

For companies, it was always going to be 30%.

But there was the Great Indian Debt Fund Tax arbitrage. If instead of buying a fixed deposit, you bought a debt mutual fund which bought bank wholesale deposits, a massive tax arbitrage worked in your favour.

If you held units for a year, then the gains were “Long Term Capital Gains”. These gains are taxed at lower rates of 10% of absolute gains, or 20% of “indexed” gains. When you index, you basically adjust your gains for inflation, and tax only what’s beyond the inflation impact.

The Example

So, if you put in Rs. 100,000 in a debt fund that returned 12% and you sold after a year, you got Rs. 112,000. Your tax used to be like this:

  • My 100,000 is adjusted up for (say) 9% inflation, so it’s now equivalent to 109,000.
  • The gain I made is only 112,000 minus 109,000 = Rs. 3,000.
  • The tax I pay is 20% of that = Rs. 600.

So for a gain of Rs. 12,000 I pay a tax of only Rs. 600 - effectively, a 5% tax!

The equivalent in a fixed deposit would have cost me, at the highest tax bracket, 30% of the interest of Rs. 12,000, or Rs. 3,600.

I pay 6x more tax with a fixed deposit!

The Result

High networth investors and corporates flocked to debt funds. There were liquid funds, income funds, gilt funds and other “debt oriented” funds. These, as of June 2014, manage over Rs. 700,000 crores.

image

(Link)

That’s a lot of money.

What’s Changed?

Finance Minister Arun Jaitley, in Budget 2014, has removed this tax arbitrage. Now, you must hold a debt fund for three years in order to claim long term capital gains taxes, otherwise the gains are “short term” in nature, don’t get the lower tax rates, are added to your income and don’t allow indexation.

Further, and thanks to Madhu for noticing this, the tax rate on long term gains used to be the lower of 20% (with indexation) or 10% (without indexation). The second part - of a lower 10% - is now gone.

From one year to three years, is a big change - a large amount of funds sit with mutual funds so that they get much lower taxes, but don’t have the visibility of staying for three years.

Remember, debt funds can’t guarantee you an interest rate. Fixed deposits from banks can. You can lose money in debt funds - in fixed deposits your principal is guaranteed. Without the lower tax, debt funds are not quite as attractive.

FMPs Might Be Dead

Fixed maturity plans that didn’t let you exit before a year, and took advantage of this tax arb are now effectively toast. Most of them are a year or so in horizon, and very few have a three year range.

When they are redeemed, and they have to be redeemed, they will incur short term capital gains tax.

New FMPs will have to be at least three years long.

This is a huge part of the industry, and if the industry loses even 100,000 cr. to bank FDs, that’s between 100 cr. and 1000 cr. (assuming 0.1% to 1% management fees) that the industry loses.

It Impacts You Now, Even For Exits After April 2014!

The change impacts you from “Assessment Year 2015-16”. In tax parlance that means it applies for Financial Year 2014-15, as assessment years are the year ahead.

If you thought you exited before the budget and are safe, you are not!

It applies retrospectively, in a way, because stuff you invested in the past will hurt you when you exit in the future. And then, if you’ve already exited earlier, you’ll pay more tax.

By the way this applies to:

  • Debt funds
  • Gold funds
  • Infrastructure non-equity funds
  • Monthly Income plans where equity is < 65%
  • Fund of Funds
  • (Don’t kill me I’m just the messenger)

Are Dividend Options Better?

Jaitley’s hurt you there as well. Earlier the dividend tax was 25% of the amount distributed, for debt funds. If a fund had Rs. 100 to distribute, it would pay out Rs. 80, and 25% of that (or Rs. 20) was paid to the government as tax.

Now with the new rules, they’ve changed that. They introduce a calculation in which you will only get Rs. 75 and Rs. 25 is paid out as tax.  (They apply the tax on what they calculate to be the distributable surplus).

Effectively, with the surcharges, your dividends are taxed at 28.2%. (It used to be 22%).

What to do?

Nothing. Just pay the darn tax. Mutual funds, even debt, continue to have their advantages. They don’t accrue tax if you don’t exit - so if you don’t need the money, you won’t pay the tax. (FDs make you pay taxes even if the money continues to compound). Second, there is no TDS on debt fund exits, which makes cash management a little bit easier.

Dividend investments make sense if you need to exit earlier than three years, if you are in a 30% bracket. But it may just be better to put the money in a fixed deposit instead.

I would continue to keep my money in the debt funds - why pay tax unless I need it? But of course if you own an FMP you don’t have a choice about the exit. FDs will probably have to be evaluated alongside a debt fund, and might win, considering the tax advantage is gone.

This is a rough part of the budget and affects the whole Mutual Fund industry. Let’s hope they can have it pushed out by another year (but don’t hold your breath).

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About the Author:
http://www.capitalmind.in
The man behind Capital Mind. Deepak is a co-founder at MarketVision, a financial knowledge company. Deepak also provides data research and consulting services, and now lives in Bangalore. Connect with him at deepakshenoy@gmail.com.

51 comments “The Murder of the Debt Mutual Fund By Closing a Tax Loophole”

If you hold a debt mutual fund for more than 3 years, can an investor get the benefit of Inflation Indexation?.

Unless this one is rolled back or pushed back, FMPs with a fixed maturity date are very likely to become Open Ended as their end date approaches, so that investors who don’t need the money right away can continue to remain in the scheme.

Another option for retirees who need regular income is to go for SWP, which was always available even now. This ensures that you withdraw only limited amounts from your corpus, and the effective tax is only on the miniscule gains, till 3 years are completed. I can do a quick calculation to illustrate, but leave it to you (don’t want to hijack your blog) :-)

do we still get indexation benefits after three years?

and are equity STCG and LTCG effected?

How can MF get around the existing FMP tax issue for the investors? Can the MF schemes merge the FMP’s with Income/Liquid schemes to ensure they don’t get redeemed automatically?

But then why would MF do the above, and get into the bad books of the FM :(

A very well written article about the impact of budget’14 on Debt funds. Thanks for this Deepak!

On one hand the FM says the tax laws should not be applied retrospectively but I guess that is just a lip service to keep MNCs happy and have a middle way with them to get moolah.

Personally I had bought FMPs during Aug/Sep/Oct 2013 period when the return were mouth-watering. Had I have known this earlier, I would have bought dynamic bond fund instead that I do normally for longer term deposits.

Though I believe that this ought to be done sooner than later and FDs/Debt funds should get same treatment. Changing the laws midway disrupts financial planning and is unfair to some extent and the better way had been to extend the indexation benefits to FDs (to ensure near +ve real rate of return)

On a longer term this is a GREAT initiatives as in longer term it would be beneficial to use this debt fund money in either capex or equity/balanced funds and would encourage investments.

Would it increase demand of listed Tax-free bonds so the liquidity of the same?

I wonder if this is going to lead to an exodus of money out of debt funds. If so, how will the mutual funds handle the redemption pressure? After all these are not some stocks you can sell at any price.

Come on.. you cannot call this tax “loophole”. Will you call no tax on LTCG of equity as tax “loophole”?

Ok, I am appalled by this new rule. Debt funds are cornerstone of my investment strategy. Some of them are considerably risky (like gilt funds). I am not affected much because my holding period is very long term but you never know what will happen in future.. Sigh!

It’s a loophole in the sense it is an arbitrage. If you invest in a one year bank deposit you pay 30%. If you buy a fund that buys a bank deposit you pay zero? That has to be a loophole no?

(Equities have no loophole. If you buy direct, no tax. If you buy through MF also, no tax)

I am sorry but I agree with Arun. A loophole is defined as “A way of escaping a difficulty, especially an omission or ambiguity in the wording of a contract or law that provides a means of evading compliance.” This was in no way an omission or ambiguity in the law but an express provision made under the law. Whenever this was introduced, the law makers in their wisdom must have had a good reason for doing so. Like you yourself and many others have pointed out, a debt fund can actually give you negative returns, which can be set off against other long term capital gains. A bank FD however cannot give negative returns and therefore cannot be treated as a capital asset. This apart, imagine an investor, who invested in a FMP 2 years ago with the hope of getting double indexation. He has been cheated. If it were just a loophole, then you could probably say that he was taking advantage of an oversight by the lawmakers, but he has on the guarantee of the lawmakers, made this investment and has all the right to feel that a huge fraud has been committed on him. Could he sue the Government for breach of contract? I wonder, maybe he should.

I agree with you that a past investor is hosed for no fault of his. There’s no way to sue the government for this, I imagine. HOpefully they can be pressured to only move it to new investments after this rule…

There is no murder or exodus possibility. 20% after indexation is still better than 30% TDS with no indexation in FD. Where will the money go if it wanted to leave?

It seems though that equity oriented funds might be one efficient option as the LTCG will be 0, although it is not flexible… and pretty sure this loophole will be plugged in a year or two as well.

30% TDS? For NRIs I guess…it’s 10% for Indians.

20% after indexation is only applicable after three years, most funds don’t have that horizon. One year money can go to FDs since the tax will apply anyhow.

Oops, I have forgotten how tax and TDS works on FDs. Unfortunately, I will need to re-educate myself.

Hi deepak,

The TDS might be 10% but then the overall interest gets added to income and then taxed accordingly. The net tax turns out to be 33% (of which 10% is deducted as TDS and remaining is paid by the individual as per his tax calculation) in the end, no? (assuming highest slab as an example).

Yes of course….

Good analysis DD!

Thanks D:) Say hi to S and A and T :)

As an investor one feels so vulnerable..investment decisions are planned based on the tenets of taxation regime existing at time of investment..so tomorrow the executive can decide to make changes to PPF maturities, NPS schemes …is n’t time to change the principles of taxation to be based on time of investment than to time of exit…(even if it turns favorable due to executive action)

Dear Mr. Deepak,

The changes will be applicable only from 1st April 2015. So any redemption before that will be treated as existinng. Please see the text from ET in this regard.

“With a view to remove this tax arbitrage, I propose to increase the rate of tax on long term capital gains from 10 per cent to 20 per cent on transfer of units of such (mutual funds other than equity oriented funds) funds,” Union Finance Minister Arun Jaitley said in his Budget speech in Parliament.

These amendments would be effective from April,1 2015 and will accordingly apply, in relation to the assessment year 2015-16 and subsequent assessment years.

Read more at:
http://economictimes.indiatimes.com/articleshow/38140991.cms?utm_source=contentofinterest&utm_medium=text&utm_campaign=cppst

This is not true. An assessment year of 2015-16 is actually a financial year of 2014-15. All budgets are like this – tax provisions apply from the 1 April of the NEXT year. So in the 2013 budget a rebate of 2000 rupees was announced, for 2013-14. This had the text “Applicable from 1 april 2014 for assessment year 2014-15″. This is how the direct tax part of the budget works.

Your are right Mr. Deepak! There is a clarification out today from the ministry in this regard.

The effective date of the increase in long-term capital gains tax on debt mutual funds is April 1, 2014, with Revenue Secretary Shaktikanta Das on Friday putting a lid on the confusion over the issue.

The new tax rate “would apply to income arising out of this source in 2014-15, for which the assessment year would be 2015-16,” Das told Business Standard, adding that if somebody has already paid advance tax, the Central Board of Direct Taxes would issue a circular to clarify the tax change separately once the Finance Bill is passed.

The confusion arose as the Finance Bill 2014-15 stated that these amendments (doubling the tax rate to 20 per cent) will take effect from April 1, 2015 for the assessment year 2015-16 and subsequent years.

Hi Mr. Deepak,

As i understand, Ultra short term debt mutual funds are not affected hugely right?

No, they are. All non-equity mutual funds are impacted.

Does this timeline for investment date or exit date.
For ex – i invested in Oct 2013 and will exit in Nov 14 in an FMP. Will i have to pay tax as marginal income as it is less than 3 years. Though i invested before this new tax announcement. ?

Yes, this applies. It applies on the exits after 1 april 2014

So, one should switch to dividend option from the growth option for the one year FMPs?

Tax will apply at approximately 25-26%, rather than 33%..

Dividend is still an effective tax of 28% (25% plus surcharge). It’s better than the top tax bracket of 33% of course.

Best option from tax point of view now seems to be arbitrage funds for risk averse.

Hi Deepak,

Is this change in tax applicable also for FMPs bought before 31 March 2014 but maturing sometime this financial year. Thanks!

Yes, unfortunately

Deepak,
Has he also tinkered with carry forward of Long Term Losses (upto 7 years for debt MFs) which can be adjusted with LT gains? Could u pl confirm.

Not afaik…

hi

What about balanced mutual funds? They invest upto 70-80% in equity and balance in debt. Are these free from tax?

If they are qualified as equity funds (they have to have minimum 65% in equity) then they are okay. (Like HDFC Prudence)

If they are going to be less (HDFC also had a balanced plan that has only 50% equity) they will be non-equity funds as per the tax department.

I’ve been wondering about the HDFC balanced plan. In the last year the equity portion has been close to 70% through out. So, it should qualify as an equity fund. But, if in future, in some financial year if it averages below 65% then its tax qualification might change. What a….

Say it :)

It’s all messy, this thing.

I agree.
That is my concern also. The best way is to invest in mutual funds which are explicit about minimum equity %age in Scheme Information Document.
I think HDFC balanced has mandate of average 60% equity with 20% deviation (so it can range from 54% to 66%.) I wonder why they allowed to go equity %age till 70%.

I think the FM should look at the provisions for FMPs between 1 year and 3 years. Retail investors made these investments in accordance with the law. Ideally provisions should be applicable to investments made after the 10th of july. Else what stops PPF withdrawls to be taxed at withdrawal tomorrow. Also, in the case of FMPs I as an investor have little choice right now about holding my current investments between 1 and 3 years for a period greater than 3 years unlike investors in other bond funds. So either current FMP investments must be excluded from the provision or he should allow the option to individuals to extend their investments in the FMPs between 1 and 3 years to beyond 3 years by allowing these schemes to become open ended or the maturity periods being modified.

Agree with the suggestion.

I redeemed my ultra liquid fund just a week before budget as it crossed 1 year mark, in an anticipation that it is now LTCG :-( ….any ways I have to live with fact and have to pay STCG now. On other side, now I am planning to depend on Arbitrage funds to park money for 1+ year, earlier I used to depend on debt MF. Arbitrage have returns comperable to debt MF and by DNA they are equity MF and treated same way for calculating tax gains.

Be careful with Arbitrage Funds. If everybody rushes to these funds then arbitrage will reduce and yields will be paltry. Then Fund Manager will keep the money in deposits (if no arbitrage opportunity is available). Then it will become debt fund. It happened to me earlier.
Secondly, Arbitrage Funds cannot take short positions in Derivative Market. So these funds perform best in rising markets.
My advise to you is to forget Arbitrage Funds

After thinking deeply over last 3 days I feel the best advice under these circumstances is what Deepak says “Do nothing”.

Dear Deepak,

So what is the result of this taxation. Retail investor have limited exposure to debt fund (as per Jaitley) fine. Will there be a mass exodus of corporate long term funds in to fixed deposits (many companies have invested their long term cash in MF) which offers safety to capital (unlike mF). If so, the NAV may be affected so whoever retail investor (like me) invested in such funds will suffer right?

Whats your assesment on corporate money moving back to FD due to above taxation change. In this case, the bank will get lots of funds therefore should invest in some of the bank stocks as it would be the ultimate beneficiary. Banks are booking long term FDs in the range of 8.5% but leds at 10+ to 15% depending upon industry, so there could be huge boost to NIMs right!

Liquid funds are unlikely to move – they still offer a better deal for corporates overnight or over the weekend.

longer term cash in MF – I believe that at current rates exodus into FD is possible, since net yields are about 8.5% or so. If debt yields go up beyond FD, money will move to debt funds. Many income funds have a 1 year exit load so money might not move immediately but on renewal corporates might move to FDs instead for cash management. FMPs will be the biggest hit.

This is ridiculous as in the way it has been brought in without any care for investment horizons…especially as debt investors took a big knock back in July when interest rates were spiked up due to the mis management of the fisc….where is he going to fund his deficit from if there is no incentive for investors to earn interest above inflation – the issue here is not that there is a loophole…it is that as a citizen I am entitled to earn interest on my funds that at least equals the inflation that the Government introduces in the system…taking away this ability effectively means that the Government is forcing me to earn negative real returns…and that pisses me off

I think there would not be much exodus. Not even 20%.
The only impact is there will be no inflow for next 1 year. All investors would let existing investments age for next 2 years before making new investments.

That is also my strategy. I will keep enough money – generated from my cash flow – in my savings account so that I don’t have to redeem my debt mutual funds for next 2 years. After having enough money in my savings account, I can begin new investments in debt mutual funds again. Really, not much impact for debt mutual funds.
Debt mutual funds are taxed only once – on exit. FD are taxed every year. Until that “loophole” is removed, debt mutual fund will remain a favourite choice.

Existing FMPs that have been already taken with 366-371 day duration that mature during FY14-15 would get impacted. There is no way a subscriber can even decide to hold these for another 2 years, as the proceeds are automatically returned on completion of the term. This is where the investors would feel hurt the most. This has come as a rude shock and there is absolutely nothing one can do about it. I hope this understanding is correct!

What is impact on those 367 days FMP’s invested after April 2013 & getting matured for payment now ? How will they be taxed. Can some learned readers clarify ? Also what about those 13 months FMP’s which were already matured during April ~June 2014. Ideally this amendment should apply for FMP”s being invested now onwards,not restrospectively. if applied retrosepctively all investors who invested on the basis of offered issue conditions during second half of 2013 stands to lose big due to treatment of redemption as STCG now !

Does it not amount to retrospective? What would you say if interest on tax free bonds are now made taxable? Why then amendment is worded to apply to redemptions/maturity of Investments made when the law was clearly & without any ambiguity >12m being long term capital gains? Why not amend so that it applies only to Investments made now, prospectively i.e. investments made after say 1st Oct 2014? Alternatively as proposed in DTC apply the period of 12 months from the end of the financial year? Hope fairness prevails


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