The mutual fund investment community received a shocker last month when the long-term capital gain (LTCG) tax benefit was withdrawn from debt mutual funds from this financial year.
For the uninitiated, the investments in debt mutual funds were used to enjoy indexation benefits after 3 years of holding. This was applicable to international funds, gold funds, and any other funds having domestic equity exposure of less than 65%.
For example, if someone keeps money in FDs that are offering 8%, the interest income was taxed at the slab rate. Therefore, at a higher tax slab of 30%, post-tax returns come out to be 5.60%.
On the other hand, the original investment in debt funds after 3 years was allowed to be adjusted by inflation and taxed at a flat 20%. Thus, returns on debt funds usually attracted an effective tax rate of 4-12% depending upon the inflation during the holding period and the number of indexation years. Thus, the post-tax returns of a debt MF generating 8% returns were roughly 7-7.5%, a staggering difference of 1.5-2% per annum over FD returns.
It became a choice of investment for retirees and conservative investors. With this major change, will debt funds continue to attract flows? Yes, and I have the following reasons to believe so:
1. Mutual fund industry will need to innovate and expand the issuer base to include higher-yielding securities. This will help in generating higher nominal returns to compensate for the loss of tax benefits in order to attract demand. This I believe should happen over the next 1-2 years.
2. Debt MFs still do not attract tax on accrued gains which is the case in FDs. This delaying of tax payment helps generate higher returns due to the benefit of compounding over the delayed tax part.
3. Debt MFs are not subjected to penalty in terms of lower interest rates irrespective of the time of redemption. Whereas in the case of FDs, the interest rates are reduced if the redemption is done before the maturity period. Therefore, even if the redemption in Debt MFs is done after a few days, one gets annualized returns expected to be received over the average portfolio maturity (provided everything else remains constant).
4. There wouldn’t be any change in the flows of investments in Debt MFs where the intended holding period was less than 3 years.
In my view, directionally, the policymakers will remove the tax advantages on all the investment avenues (barring a few which are nascent and need support) making it a flat structure for all the asset classes. The asset class prices will adjust to enable higher potential post-tax returns.
As Benjamin Franklin once said “In this world, nothing can be said to be certain, except death and taxes”
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