Reboot your portfolio

Written by Saikat Neogi | Updated: Jul 29 2014, 07:11am hrs
Fixed maturity plans (FMPs) of less than three years will no longer have an edge over bank fixed deposits in terms of taxation. For all non-equity funds, the budget has doubled the rate of long-term capital gains tax to 20% with indexation and extended the minimum tenure for long-term capital gains from one year to three years. This will impact over 65 lakh retail portfolios across all categories of non-equity mutual funds with assets under management (AUM) of around R36,000 crore as on March 2014.

Click here for graph

The finance minister, however, clarified last week in Parliament that the higher rate of 20% will not apply to units sold between April 1 and July 10. But units of debt-oriented MFs sold after July 10 will attract 20% tax against 10% earlier. Sudhir Kapadia, national tax leader at EY, feels it is good that the finance minister made changes to capital gains tax on non-equity MF redemptions applicable from July 11 and not retroactively.

However, the ministry of finance should now work with the Securities and Exchange Board of India (Sebi) to make amendments to FMP regulations and allow these to become open-ended or else investors in FMP will be unfairly taxed on a short-term basis as the rules were different when they invested, he adds.

Before changes to the 2014 Budget, short-term capital gains with holding period of less than one year were taxed at a marginal tax rate. There is no change in this structure after the budget. For investments over a period of one year, long-term capital gains were applicable at 10% without indexation, or 20% with indexation. Now, long-term has been extended to three years and will be taxable at 20% with indexation.

Fixed maturity plans (FMPs)

They are closed-ended funds and fund houses invest in securities maturing on or before the maturity of the scheme. Earlier, fund houses used to launch 380-day FMPs in the last week of March. After the scheme matured in April next year, investors took double indexation benefit.

Niranjan Risbood, director, fund research at Morningstar India, says that many asset management companies are offering an option to roll over one-year FMPs for an additional two years with the consent of investors.

Investors should consider this option to roll over in case they definitely do not require the money for the next two years. In such a scenario, these FMPs are likely to give better post-tax returns than bank FDs, he says.

Brijesh Damodaran, founder and managing partner at Zeus Wealth Ways LLP, says that based on ones liquidity needs, one should look at extending existing FMPs of one year to three years now. If one doesnt have immediate liquidity needs and falls in the 30% tax bracket, then extending the time period of FMPs is recommended. However, if one falls in the lower tax bracket, then one should revisit the portfolio and not roll it over, he says.

Bank FDs or FMPs

The increase in long-term capital gains tax on debt-oriented mutual funds was done to bring parity with banks and other debt instruments. In case of bank fixed deposits, tax is paid on the interest earned every year at the marginal rate applicable to the investor. So, in the new tax structure, does it make sense to invest in a bank fixed deposit

There are two scenarios under which investing in debt funds is still beneficial compared to bank fixed deposits.

First, falling interest rates, where debt funds would benefit as bond prices increase. Second, where the investment horizon is more than three years, in which case the tax efficiency of investing in debt funds would be higher than bank fixed deposits.

For other cases, the investor could prefer bank fixed deposits given the guaranteed returns.

The advantage bank fixed deposits have over a three-year FMP is liquidity. In case of any emergency, bank fixed deposits can be liquidated, with some penalty for premature withdrawal. But, in FMPs, one just cannot liquidate the money as the funds are closed-ended. One can only withdraw the money after the scheme matures. Moreover, if you are in the 10-20% tax bracket, bank fixed deposits or corporate fixed deposits with AAA rating could be considered. However, if one doesnt need to liquidate the investments and falls in the 30% tax bracket, a three-year FMP would make sense.

Systematic withdrawal plans (SWPs)

Investors should now start systematic withdrawals only after three years to save taxes on short-term gains. A systematic withdrawal plan would not be beneficial compared to an FD unless investment in debt fund completes three years. For an investment horizon of less than three years, such withdrawals would be taxed as short term capital gains, says Risbood.

Ultra short-term debt funds

Investments in ultra short-term funds are mostly made by companies and high-networth individuals for a short time horizon of 15 days to 6 months. There will not be any change in the tax structure of these funds and these investments will not see any major impact. These short-term funds will be taxed as short-term capital gains or a dividend distribution tax of 25% for individuals.

After the new tax structure in debt mutual funds, ultra short-term debt funds are still attractive compared with bank fixed deposits. One should look at the dividend reinvestment option in ultra short-term bond funds, irrespective of the investment period, says Damodaran. So, investors of non-equity mutual funds will have to rejig their portfolios to make tax-efficient gains.