Debt fund taxation changes marginally positive for life insurers, banks: CLSA

The Finance Bill 2023, passed in the Lok Sabha with over 45 amendments on Friday, has introduced amendments to taxation on debt mutual funds. Now, the capital gains from debt mutual funds will be treated as short-term capital gains, bringing it at par with FDs (fixed deposits). This means that any gains arising from debt mutual funds (held for less than 3 years or more) will be added to the investor's taxable income and taxed at their income tax slab rate. The proposed changes would be applicable to investments made on or after April 1, 2023.

At present, investors in debt funds pay income tax on capital gains according to the income tax slab for a holding period of three years. After three years, these funds pay either 20 percent with indexation benefits or 10 percent without indexation.

Market experts are not happy with the most recent changes in the taxation of Debt mutual funds (MFs). This is negative for MFs – Debt (ex liquid), which contributes 19 percent of assets under management (AUMs) and 11-14 percent of revenues, global brokerage house CLSA said in a recent note.

"With this change and the changes proposed in the budget on life savings products, there is no tax arbitrage left across debt instruments be it bank deposits, debt MFs, or life insurance savings products," it said.

The brokerage, however, noted that Liquid MFs of ₹6.6 lakh crore will not be impacted materially as they are anyway a short-term product and there is no material change in tax attractiveness.

But, for AMCs under its coverage, revenue contribution from non-liquid debt products is 11-14 percent and CLSA believes this is moderate to low impact as the bulk of the revenue/profitability for AMCs accrues from equity AUMs and non-liquid debt AUMs.

Marginally positive for life insurers, banks

There is no amendment to the tax changes proposed in the budget for the life insurers and hence status quo remains with returns on incremental premiums over ₹5 lakh to be taxed at the individual tax rate.

As per the brokerage, while this will impact non-PAR (participating) savings sales vs pre-budget levels, the change in taxation for debt MFs now bridges the tax arbitrage and brings all debt products at par. “So life insurers from being a superior product pre-budget (no tax on debt savings) moved to being an inferior product post-budget (full tax on premiums over ₹5 lakh) and now it is neutral as alternate debt investments are also taxed at marginal tax rate,” it said.

At these valuations, CLSA believes this is a marginal positive for life insurers. It also said that this amendment (debt MF taxation) is also a small positive for banks.

"Post the budget changes in insurance and amendment changes proposed for debt MFs, tax arbitrage vs bank deposits is gone. Earlier interest on bank deposits was taxed at the individual tax rate and debt MFs enjoyed LTCG of 20 percent with indexation and life savings products enjoyed tax-free returns. At the margin, this is positive for banks but quantum cannot be very high as bank deposits’ market size is ₹180 lakh crore vs total debt MF size of ₹8 lakh crore," stated the brokerage.

Other experts also see this new amendment as a major loss for the debt MF industry.

VK Vijayakymar, Chief Investment Strategist at Geojit Financial Services, noted that the changes in debt fund taxation, also applicable to gold funds, international funds and domestic fund of funds, will have far-reaching consequences. When STCGs (short-term capital gains) are imposed on debt funds, the taxation will be similar to the taxation of bank FDs. This is a blow to the debt market.

According to Vijayakumar, the important consequences will be as follows:

1. More money will move to bank FDs.

2. Equity mutual funds and hybrid funds with above 35% investment in equity will attract more investment.

3. Sovereign Gold Bonds will attract more funds.

Since investments up to 31st March 2023 will be grandfathered, investors can invest in debt funds and international funds in the next few days up to 31st March.

The biggest gainer will be the exchequer with increasing tax revenue.

"Even though the proposed changes are a blow to the debt market, these changes simplify the tax system by taxing all fixed-income products. This proposed reform mainly targets HNIs and family offices who gained from the tax arbitrage under the existing tax regime. The proposed changes are in line with the philosophy of the new default personal income tax regime without exemptions. India’s tax policy is moving to a simple, consistent tax regime with no room for tax exemptions and arbitrage," the expert pointed out.

Meanwhile, Sandeep Bagla, CEO, Trust Mutual Fund, also said that while there is likely to be no impact in the short term but this (taxation of debt MF amendment) could impact the ability of mutual funds to attract debt flows in the long term.

"Last 1-2 years, MFs have seen outflows from debt schemes, in spite of the tax benefit. The only segment that saw inflows was the spate of target maturity funds which were passively holding G-Secs, mimicking FDs but with tax benefits. Investors may be reluctant to redeem even after completion of 3 years now as incremental income from these investments may remain tax efficient. Few investors may remain invested wanting to defer tax as tax is payable only at redemption. Incremental inflows will come into funds that are able to manage their portfolios actively and generate inflation-beating returns for investors. There is likely to be no impact in the short term but could impact the ability of mutual funds to attract debt flows in the long term," he noted.

Tapati Ghose, Partner, Deloitte India said, "The proposed move seems to bring taxation of such mutual funds on par with bank deposits which are taxed at slab rates. While the proposed amendment shall impact the transfer of the units of specified mutual funds acquired on or after 1 April 2023 while the grandfathering benefit is not available for market-linked debentures. One may recall that in 2014, the government had changed the taxation of debt mutual funds. At that point in time, the finance minister had indicated that beneficial tax treatment or debt mutual funds allow tax arbitrage opportunities because direct investments in banks and other debt instruments attract a higher rate of tax. The proposed move seems to be a step further in this direction" said Ghose.