With indexation benefit phased out, debt mutual funds have lost one of their key pulls, evoking grumbles from many, and praise from some.
The knee-jerk reaction of the amendment was that the debt mutual funds would lose some of their charm among retail investors as taxation benefit is phased out, particularly among the investors who fall under the maximum slab of 30 percent.
For the unversed, let us explain what does the new rule say. As per the latest amendment in the Finance Bill, 2023 (which is now an Act), debt mutual fund investors are no longer entitled to indexation benefit, and the gains received from their redemption will be simply added to the gross income of investors and treated as per the tax slab.
Earlier, any debt mutual fund investment, if sold after holding for over three years, used to be treated for long term capital gains (LTCG) benefit.
Experts say that like everything else, the impact of amendment cannot be seen as black or white since it, too, has shades of grey in it.
Tax Arbitrage to end
One of the intentions of this amendment, says one fund house’s CEO, is to rectify a loophole in the tax rules. Currently, almost every fund house runs a target maturity fund wherein they simply buy government securities and make use of tax benefits while the same securities are not entitled to those tax benefits when bought outside of mutual fund ecosystem.
“By removing the tax exemption, the regulator has removed the tax arbitrage which these fund houses were using as a loophole in the tax rules,” says Sandeep Bagla, CEO of TRUST Mutual Fund.
Apart from this, he says, only those investments will face an impact that are sold after holding for more than three years. “Almost 60-70 percent of debt fund investments are held for lower than one year. So, they were not supposed to get the capital gains benefit anyway,” he adds.
Mr Bagla also says that returns given by long term debt funds are still better than those of term deposits.
“The Crisil Bond index indicates that the yield of 10-year-bonds stood at 8.75 percent. One can’t earn this return via FDs. And like equity, debt investments are also subject to uncertainties. One should consider other factors such as interest rates and inflation before making allocation in debt funds. It is important to make gains by looking at debt dynamically rather than being an arbitrage taker,” says Mr Bagla.
Score over other fixed income instruments
Vishal Goenka, Co-Founder, IndiaBonds believes that the proposed changes will make direct bond investments as an attractive option.
“Taxation rules across debt investments should be uniform as this simplifies the choice for investors who should focus on analysing the investment itself rather than the taxation disparity. We welcome the proposed changes as it creates a uniform level playing field between debt mutual fund and direct bond investment," says Mr Goenka.
At the same time, Sridharan Sundaram, SEBI-registered co-founder of Wealth Ladder Direct, also assert that debt mutual funds, regardless of phasing out of tax benefits, will continue to score over fixed deposits.
International & gold funds
He, however, mentions that losing indexation benefits by international funds and gold mutual funds could have been avoided.
While speaking about international funds, he says that these funds are already subject to a number of risks such as currency and market risk. “Now these funds will face taxation risks also,” he says.
Regarding gold mutual funds, Mr Sundaram says that it is unfair that one category of gold funds (mutual funds) will not lose the tax benefit while the other category (gold ETF) will continue to be considered for LTCG benefit since they fall under the bracket of equity.
Ravi Saraogi, CFA and Co-founder, Samasthiti Advisors echoes the same sentiments when he says that investment in international funds will get less attractive when they no longer enjoy the long-term capital gains (LTCG) benefit.
“It (the amendment) effectively means telling investors not to get international diversification. Moreover, debt mutual funds are like marketable securities and it is not fair to treat them at par with fixed deposits. So, it is not the right way to create a level playing field,” he says.
In conclusion, one can say that investment in debt mutual funds, despite the amendment, will continue to draw investors for the higher returns they offer as compared to other fixed income instruments. However, the same may not be true for other categories such as international funds and gold funds.