Debt MFs lose sheen after tax-arbitrage benefit removed

Written by Suraj Nangia | Updated: Jul 25 2014, 08:10am hrs
The Budget provision relating to taxing of long-term capital gains on sale of debt mutual fund units could have far-reaching implications. The nature of gain on sale of units of such funds would now be considered long term only if these units are held by the seller for more than 36 months, which earlier was only 12 months.

Since the long-term nature of capital gains entitles the seller to apply indexation on the cost of acquisition, unit holders of debt mutual funds will now have to hold these for over three years to claim the benefit. On the other hand, if such units of debt funds are sold before three years, any capital gains arising on such sale shall be short term in nature and taxed at the applicable slab rates of the investor.

Another noteworthy change in relation to taxability of non-equity oriented mutual funds is the tax rate applicable on long-term capital gains. Before the budgetary proposal, long-term gains on sale of non-equity oriented mutual funds were taxed at 20% of gains (computed after indexation of cost) or 10% of gains (computed without indexation).

Under the proposed law, long-term gains on sale of non-equity oriented mutual funds sale by the unit-holder after holding it for more than three years shall be taxed at a flat 20% after giving indexation benefit. This is a major change in the taxation rules of non-equity oriented funds, since the option of beneficial taxation of 10% without indexation is proposed to be withdrawn.

A clarification is awaited on whether this change is effective from the current financial year, i.e., April 1, 2014 or from the Budget Day, i.e., July 10, 2014.

One of the main reasons why debt mutual funds had become a preferred investment option over bank fixed deposit was due to possible tax arbitrage. In a bank deposit, interest earned is taxed as income in the year in which it accrues at the applicable slab rate. However, in the case of a debt fund, investing and exiting a year later could result in either nominal tax at 20% (with indexation benefit) or lower tax rate of 10% on the gains, and that too at the time of exit.

To illustrate, suppose R100 is invested in the units of debt fund, which is sold for R110 after a year. Assuming 8% inflation, the taxable gain would be adjusted down to R2, since the cost of investment of R100 would be indexed to R108, making the taxable gains lower. Applying the beneficial tax rate of 20% on R2, the tax outflow would be just 40 paise.

On the contrary, had this sum been invested in a fixed deposit, interest of R10 would be counted as income and the tax on that would range from R1 to R3, based on the applicable tax bracket. In case of a corporate assessee, the tax would be over R3. Thus, companies could reduce their tax liability by around 90% from R3 down to just 40 paise for every R10 earned, by investing their surplus funds into units of debt fund schemes.

This arbitrage led companies to invest large surplus funds in debt mutual funds in recent years. Now, such investors need to hold debt funds for over three years to qualify for long-term capital gains.

For gains arising on sale of units before the expiry of three years, the tax treatment on debt mutual funds is akin to fixed deposits. Since fixed deposits are comparatively safe, short-term investment in debt funds may no longer be preferred.

The writer is executive director, Nangia & Co