Debt Mutual Fund loses its Tax Arbitrage Advantage
As soon as Hon’ble Finance Minister Shri Arun Jaitley delivered his speech on change in tax implication on debt mutual fund, the last rituals of debt mutual fund begun. The changes made in Budget 2014 regarding Debt Mutual Fund are so drastic that some experts said that Arun Jaitley has murdered Debt Mutual Fund.
Let’s start with the basics of why debt mutual fund was so alluring and what has budget 2014 done to ruin it.
Scenario prior to Budget 2014
- Tax @ 10% without Indexation or Tax @ 20% with Indexation.
- Units held for more than 12 months are Long term capital assets
Debt mutual funds, which were giving neck-to-neck competition to bank fixed deposits, have lost their tax advantage.
Considering tax bracket of 10%, if you invest in bank fixed deposit, earning approximate return of 9% p.a. the actual yield comes to 8.1%. But instead of investing into the bank fixed deposit if you bought a debt mutual fund (FMPs i.e. Fixed Maturity Plans) which invested in bank fixed deposits, you would have gained a massive tax arbitrage.
If you held units for more than 12 months, it used to fall in long term capital asset and gains were long term capital gains. This LTCG was taxed at lowest tax rate of 10% without indexation or 20% with indexation.
Sanyam invested Rs 1,00,000 in a debt mutual fund earning return of 12% which he sold after one year. Now he got Rs 1,12,000 as sale value. The tax used to be lower of:
Without Indexation @ 10%
- Rs 1,12,000 – Rs 1,00,000 = Rs 12,000 * 10% =Rs 1,200
With Indexation @ 20% considering inflation of 10%
- Rs 1,12,000 – (Rs 1,00,000 + Rs 1,00,000 * 10%)
- Rs 1,12,000 – Rs 1,10,000 = Rs 2,000 * 20% = 400
If the amount is invested in the bank fixed deposit to earn the same amount of return, the tax would have been
- Rs 12,000 * 10% = Rs 1,200 (tax bracket of 10%)
As you can see from the above example, the tax on fixed deposit was as much as 3 times of what in debt mutual fund.
Due to this tax arbitrage advantage HNI (High Net-worth Investors) and corporate used to put money in debt mutual fund such as gilt funds, income funds and other debt oriented funds.
Changes made in Budget 2014
- Tax @ 20% with Indexation (10% taxation was removed)
- Units held for more than 36 months are Long term capital assets.
Budget 2014 has removed the tax arbitrage by replacing the holding period of 12 months with 36 months in order to tag the capital gains as long term capital gains. If the units are sold before 3 years than the capital gains would be short term which is added in your income and taxed at the normal rate without indexation.
In addition to above, there was an option with the assessee to pay tax at the lower of 10% without indexation or 20% with indexation which is now removed. Now, there is only one tax rate of 20% with indexation.
Above example after budget 2014:
If Units sold after one year, the gains would be short term and no indexation is available, tax would be:
- Rs 12,000 * 10% = Rs 1,200
Same as the tax under bank fixed deposit. Thus, removing the tax edge of debt mutual fund over bank fixed deposit.
Now Fixed Deposit becomes more promising because Debt mutual funds can’t guarantee you an interest rate but 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.
The change is going to come in effect from Assessment Year 2015-16 i.e. from the Financial Year 2014-15 and subsequent years.
Even if you have paid tax for the current financial 2014-15, you are still covered under this amendment as this is retrospective and required to pay the tax as per amended law.