The Centre’s move to remove long-term tax benefits from debt mutual funds will take away the tax advantage such instruments used to enjoy over fixed deposits, and lead to a certain rise in deposit inflows, bankers said.
In an amendment to the Finance Bill, 2023, the Centre said capital gains on investments in debt funds, which invest 35% or less in equity shares of domestic companies, will be taxed at an individual’s tax slab from April 1. Currently, gains from all these mutual funds, which are held for more than three years, are taxed at a lower rate of 20% with indexation benefit, or 10% without indexation.
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“…it will take away the tax advantage that debt funds enjoyed over fixed deposits (FD). Interest income from bank FDs are taxed at an individual’s income tax slab rate. With this change, debt funds will come at par with FDs on the taxation front,” said Murali Ramakrishnan, MD & CEO, South Indian Bank.
The average return from debt funds is around 6.5%-7.25%, the MD said, whereas bank deposits earn close to 7.25%. “Once the above changes come into effect, the benefit of lesser tax will not be there for debt funds. For bank deposits, it may lead to a favourable move in the current scenario where both the interest rates are similar and fixed deposits offer a return that is guaranteed. It also depends on the individual risk appetite which would decide the choice of instrument,” he added.
Suresh Khatanhar, deputy MD at IDBI Bank, said as debt funds lose benefit of indexation, certain high net worth individuals (HNI), ultra HNI and institutional investors may move money from these funds and divert it to banks’ deposits. Fixed maturity plans and target maturity funds may also face pressure, he said.
“The mutual funds were using such funds to fund the working capital needs and NCDs of corporates. If they get lesser funds due to end of the arbitrage, it will be also positives for banks, as this business opportunity will flow to banks for refinance. In a nutshell, it is positive for the banks,” he added.
End of LTCG on debt funds not only increases the taxation rates by bringing it to slab rates, but also takes away the benefit of indexation, said Rathish R, senior vice president at Federal Bank. This negative impact on debt funds increases the lucrativeness of bank FDs and can affect the flows in debt funds, he added.
“But debt funds still have the advantage of not having a penalty for premature termination (which may be an exit load, if any), no tax until redemption, reduced issuer-specific risk due to a diversified portfolio, and the ability to carry forward capital gains and losses,” the official said. “It also affects international equity mutual funds/FoF and gold ETFs/funds, thereby making direct foreign equity/ETFs through LRS mode more tax efficient than feeder fund structure,” he added.
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Brokerage CLSA said at the margin this looks positive for banks, but quantum of shift to deposits cannot be very high, as bank deposits’ market size is Rs 180 trillion, against the total debt mutual fund size of Rs 8 trillion. Banks would also gain from more business from non-bank lenders, as they reduce their reliance on mutual funds for securing funds.
Umesh Revankar, vice chairman at Shriram Finance, said he sees customers preferring deposits of banks and NBFC for better returns, rather than debt funds. “The non-deposit-taking NBFCs would either move to more bank borrowings, or come out with retail NCD issues,” he said.
Experts say in the absence of an LTCG framework for debt funds, mutual funds will now have to be able to add extra risk-adjusted returns to attract customers. “The tax arbitrage that was available at an “instrument” level seems to be getting evened out across the board be it debt MF or MLD (market linked debenture). However, this will benefit the corporate bond market where there will be renewed interest from retail investors, and this will also add depth to the liquidity which again will mean better pricing for the end customer,” said Srikanth Subramanian, CEO, Kotak Cherry.
Madan Sabnavis, chief economist at Bank of Baroda, shared similar thoughts. He said the Centre’s move will make debt mutual funds less attractive, while banks should gain. However, the interest rate differential is important. As long as banks offer competitive rates, they will benefit, as they have the added feature of safety. There will be a shift to deposits though one has to see how investors view the situation, Sabnavis said.
“There can be migration from debt to hybrid schemes which have the benefit of equity when it comes to capital gains. While preference for deposits will rise, given that banks are offering high rates for certain tenures, the quantum of migration cannot be assessed now. The choice is really between equity and hybrid funds on the one hand, and fixed deposits on the other. Some of the AAA-rated companies are also offering high rates which would also be considered by savers,” he added.