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The Murder of the Debt Mutual Fund By Closing a Tax Loophole



Invested in an FMP?

Bought a Liquid Fund And Stuck around for a Year?

Bought Debt Funds for the “Inflation Indexation”?

You’re going to hate Arun Jaitley.


Let’s start with the basics. You can invest in a fixed deposit with banks. Which pays you interest. The interest is added to your income, and taxed at the highest rate you qualify in. So a 9% fixed deposit falls down to 6.3% if you are in the 30% bracket.

For companies, it was always going to be 30%.

But there was the Great Indian Debt Fund Tax arbitrage. If instead of buying a fixed deposit, you bought a debt mutual fund which bought bank wholesale deposits, a massive tax arbitrage worked in your favour.

If you held units for a year, then the gains were “Long Term Capital Gains”. These gains are taxed at lower rates of 10% of absolute gains, or 20% of “indexed” gains. When you index, you basically adjust your gains for inflation, and tax only what’s beyond the inflation impact.

The Example

So, if you put in Rs. 100,000 in a debt fund that returned 12% and you sold after a year, you got Rs. 112,000. Your tax used to be like this:

  • My 100,000 is adjusted up for (say) 9% inflation, so it’s now equivalent to 109,000.
  • The gain I made is only 112,000 minus 109,000 = Rs. 3,000.
  • The tax I pay is 20% of that = Rs. 600.

So for a gain of Rs. 12,000 I pay a tax of only Rs. 600 – effectively, a 5% tax!

The equivalent in a fixed deposit would have cost me, at the highest tax bracket, 30% of the interest of Rs. 12,000, or Rs. 3,600.

I pay 6x more tax with a fixed deposit!

The Result

High networth investors and corporates flocked to debt funds. There were liquid funds, income funds, gilt funds and other “debt oriented” funds. These, as of June 2014, manage over Rs. 700,000 crores.



That’s a lot of money.

What’s Changed?

Finance Minister Arun Jaitley, in Budget 2014, has removed this tax arbitrage. Now, you must hold a debt fund for three years in order to claim long term capital gains taxes, otherwise the gains are “short term” in nature, don’t get the lower tax rates, are added to your income and don’t allow indexation.

Further, and thanks to Madhu for noticing this, the tax rate on long term gains used to be the lower of 20% (with indexation) or 10% (without indexation). The second part – of a lower 10% – is now gone.

From one year to three years, is a big change – a large amount of funds sit with mutual funds so that they get much lower taxes, but don’t have the visibility of staying for three years.

Remember, debt funds can’t guarantee you an interest rate. Fixed deposits from banks can. You can lose money in debt funds – in fixed deposits your principal is guaranteed. Without the lower tax, debt funds are not quite as attractive.

FMPs Might Be Dead

Fixed maturity plans that didn’t let you exit before a year, and took advantage of this tax arb are now effectively toast. Most of them are a year or so in horizon, and very few have a three year range.

When they are redeemed, and they have to be redeemed, they will incur short term capital gains tax.

New FMPs will have to be at least three years long.

This is a huge part of the industry, and if the industry loses even 100,000 cr. to bank FDs, that’s between 100 cr. and 1000 cr. (assuming 0.1% to 1% management fees) that the industry loses.

It Impacts You Now, Even For Exits After April 2014!

The change impacts you from “Assessment Year 2015-16”. In tax parlance that means it applies for Financial Year 2014-15, as assessment years are the year ahead.

If you thought you exited before the budget and are safe, you are not!

It applies retrospectively, in a way, because stuff you invested in the past will hurt you when you exit in the future. And then, if you’ve already exited earlier, you’ll pay more tax.

By the way this applies to:

  • Debt funds
  • Gold funds
  • Infrastructure non-equity funds
  • Monthly Income plans where equity is < 65%
  • Fund of Funds
  • (Don’t kill me I’m just the messenger)

Are Dividend Options Better?

Jaitley’s hurt you there as well. Earlier the dividend tax was 25% of the amount distributed, for debt funds. If a fund had Rs. 100 to distribute, it would pay out Rs. 80, and 25% of that (or Rs. 20) was paid to the government as tax.

Now with the new rules, they’ve changed that. They introduce a calculation in which you will only get Rs. 75 and Rs. 25 is paid out as tax.  (They apply the tax on what they calculate to be the distributable surplus).

Effectively, with the surcharges, your dividends are taxed at 28.2%. (It used to be 22%).

What to do?

Nothing. Just pay the darn tax. Mutual funds, even debt, continue to have their advantages. They don’t accrue tax if you don’t exit – so if you don’t need the money, you won’t pay the tax. (FDs make you pay taxes even if the money continues to compound). Second, there is no TDS on debt fund exits, which makes cash management a little bit easier.

Dividend investments make sense if you need to exit earlier than three years, if you are in a 30% bracket. But it may just be better to put the money in a fixed deposit instead.

I would continue to keep my money in the debt funds – why pay tax unless I need it? But of course if you own an FMP you don’t have a choice about the exit. FDs will probably have to be evaluated alongside a debt fund, and might win, considering the tax advantage is gone.

This is a rough part of the budget and affects the whole Mutual Fund industry. Let’s hope they can have it pushed out by another year (but don’t hold your breath).

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