Changes in Mutual Fund Taxation in 2014 Budget

What has budget changed in terms of taxation of mutual funds ?

1) It increased the duration for long term benefits of all non-equity funds from 1 years to 3 years. This means all gains arising from sales that occur before 3 years holding time will be considered as short term capital gains. Short term capital gains are taxed at marginal rate of the investor.

2) There were two options to compute taxes for long term capital gains arising out of non-equity mutual funds. a) 10% tax without indexation and b) 20% tax with indexation. This budget removed the option (a). Now only option (b) is available.

3) There are changes in the dividend taxation also. That is subject of another blog. Watch this space for an update. We will address only impact of the debt fund capital gain taxation in this article.


Why was it done ?

The Finance minister Mr. Jaitley gave as the justification during his budget speech, “…the capital gains arising on transfer of units held for more than a year is taxed at a concessional rate of 10% whereas direct investments in banks and other debt instruments attract a higher rate of tax. This allows tax arbitrage opportunity. This arbitrage has hardly benefited retail investors as their percentage is very small among such Mutual Fund investors.” He repeated this justification during the budget debate in the Lok Sabha on the 25th, “…was a facility which we had really given for retail investors. A bulk of it was being used by corporates and it was being used for arbitrage.”

Is this the right reason ?

We think not.

1) Today as we all know the taxation laws of corporates and individuals are different. If FM wanted to tax only the corporates, that could have been simply done by him by adjusting the tax provisions applied to corporates. Fixed Maturity Plans (popularly known as FMP) are primarily used by retail investors, conservative investors and retirees. FM very well know the impact for the retail investors who are investing in these products.

2) If debt funds are used for tax arbitrage, why this amendment included all non-equity funds as well. Why not scope it to include only debt funds ?

The amount of money invested under the non-equity scheme are around 7,00,000 Crores. Govt wanted a pie of the tax revenue coming out of these funds. Further there are rumors that Bank lobby which was losing their fixed deposits to tax efficient debt funds was behind this move to change the tax law.

What is the impact to investors ?

In July 25th speech, FM has explained this law will be implemented from July 11, 2014, the day FM presented the budget and not from April 1, 2014. This is only a small relief to investors.

With this change, the tax arbitrage enjoyed by the debt fund investors is removed partially.

What should be the debt investor strategy now ?

We at RRK Advisory advise our clients not to fret about this deal too much. Let us face the issue squarely and plan our investments accordingly.

We usually advise our clients to divide their money into short term goals and long term goals and invest as such. Short term goal money is primarily invested in debt funds and long term goal money is invested across different asset classes that includes stocks, bonds, real estate and gold.

The tax law has not changed anything in our investments meant for long term goals. This is a big positive. In the same way, anything that is needed in less than 1 year term time horizon, is saved in liquid and short term bond funds.They are also not affected. They were always taxed as short term capital gains at the same rate as savings and fixed deposit tax rates.

What is affected is investment in debt funds, FMP etc that is meant to be held for 1 to 3 years.  Fortunately what FM has taken away from the debt funds, he has not given it to bank fixed deposits. So, the bank fixed deposits still stay the same.

Bank deposits still offer fixed return, taxable every year at marginal rates, with penalty for premature withdrawal. Hence even though the debt funds have lost the tax benefits they were enjoying so long for 1-3 years duration, the alternative for them, that is the bank fixed deposits still remain bad as far as taxation is concerned. So, we don’t think the debt fund investors are going to sell their debt fund holdings and move the money to the bank fixed deposits. They will whine and cry for few days, but will continue to invest in debt funds. Because that is still the intelligent way to have exposure in fixed income segment.

When the period for investments is not known, it still makes more sense to invest in debt funds than fixed deposits. For example, if an investor is saving for apartment down payment that need to be made in 2-3 years time, it is advisable for him to invest in debt funds. When there is some uncertainty in selection of apartment within a specific time period, the date of purchase or down payment may get stretched beyond 3 years, the investor would enjoy long term capital gain taxation with indexation in case of debt mutual fund investment; but a bank fixed deposit will still be taxed at marginal rate subjected to TDS every year, even after 3 years of holding.

Some investors may benefit by choosing a Balanced fund (stocks funds with 10-35% bond exposure) that matches their asset allocation requirement. Long term capital gains from Balanced funds are still remain tax exempted. No need for indexation. This might look attractive to some investors and they might prefer to hold such funds instead of holding pure equity and pure debt funds. Unfortunately there are not plenty of choices in the balanced funds segment with good performance track record. Individual investors may do well by seeking expert advice in selection of such funds that are suitable to their financial goals and time horizon.

RRK Advisory also help investors to shift funds logically meant for one goal to another goal without actually selling them. This way we post pone the actual sales and also the realization of capital gains. We tried to minimize the tax impact with some intelligent planning. This tax optimization has helped lot of our clients to save tax money even when the time horizon is reached. To find out more, contact us.

Further Reading :
This link will help you to learn more about the taxation aspects in detail.

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