Finance Bill Tweak: Winners and Losers Among Mutual Funds

The Finance Bill tweak impacts debt funds, gold, and international funds, with investors potentially facing higher tax burdens and altered risk profiles.

Finance Bill Tweak

The Indian Centre has recently amended the taxation on gains from debt funds, and as a result, some mutual fund categories will lose out while others may gain. In particular, gains from debt mutual funds with less than 35% of their stock holdings will now be taxed at the lowest tax rate for all tenures.

This means there is no longer any tax arbitrage between debt instruments like bank deposits, debt mutual funds, and life insurance savings products. 

Previously, long-term capital gains (LTCG) tax rates of 20% after indexation were applied to gains from investments in debt mutual funds that lasted longer than three years.

However, due to this new amendment, such investments are now subject to the marginal tax rate, resulting in investors bearing a higher tax burden. The Association of Mutual Funds in India will ask the finance ministry to reconsider the amendments, since this could significantly affect the performance of debt mutual funds.

Gold and international funds have also been affected by this finance bill tweak. Previously, investments in gold and international funds over three years were subject to LTCG tax at 20% with indexation. But now, these investments, too, are subject to the marginal tax rate.

This could potentially lead to investors suffering higher losses due to the increased tax burden.  

Who loses out? 

As a mutual fund distributor quoted in an Economic Times report, "Entire debt mutual funds can be the immediate losers". According to Sandeep Bagla, CEO of Trust Mutual Fund, funds that actively manage their portfolios and beat inflation will receive additional inflows.

Due to the changes making debt mutual fund gain treatments short-term capital gains, capital gains from a fund with 30% equity and 70% debt instruments would be taxed solely according to one's income tax bracket (STCG).

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It is important to note that since these amendments won't take effect until after March 31, existing investments won't suffer. 

Apart from debt funds, gold funds, pure international funds, and funds of funds are likely to lose out of this tweak. According to CLSA, the debt category (ex-liquid) contributes 19.5% of assets under management and 11.4 to 14% of revenue. 

Who wins? 

The finance bill tweak proposed by the government has been met with mixed reactions. While VK Vijayakumar, chief investment strategist at Geojit Financial Services, says it is a "blow to the debt market", Somnath Mukherjee, CIO at ASK Private Wealth, believes that it will "encourage more retail investors to take part in the debt markets directly". 

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The amendment will impose Short Term Capital Gains (STCGs) taxes on debt funds, making taxation similar to that of bank fixed deposits. This implies that more capital will flow to safer investments like bank fixed deposits, equity mutual funds, hybrid funds with a minimum equity investment of 35%, and sovereign gold bonds. 

The proposed changes adhere to the principles of the new, exemption-free default personal income tax regime. The amendments could benefit balanced advantage funds significantly while hurting conservative hybrid funds. 

Investor's risk profile to rise 

Recent changes to debt taxation in India's Finance Bill will meaningfully impact investors' allocation decisions. As Roopali Prabhu, chief investment officer for the private wealth group at JM Financial, puts it: "Investors will now have to accept a higher level of risk in order to receive the same expected returns." 

Assuming yields don't change, an investor will have to invest over 25% of their portfolio in equities to achieve a 7% per annum post-tax return over three years. This assumes a 13% equity return in line with historical averages. The previous threshold was only 15% of equity allocation.

This effectively doubles the amount of risk an investor has to take on to achieve their desired post-tax returns.

Final Thoughts

The Finance Bill tweak impacts debt, gold, and international funds, leading to increased tax burdens for some investors.

As a result, investors' risk profiles may rise, with higher equity allocations needed to achieve desired post-tax returns. The amendment could benefit balanced advantage funds while negatively affecting conservative hybrid funds.


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