FDs have edge over debt funds

BUDGET IMPACT

Hike in dividend distribution tax on debt plans may see cash switch to FDs.

The competition between bank fixed deposits and liquid mutual funds will now be more fierce. The increase in the dividend distribution tax (DDT) on debt schemes could prompt corporates to park short-term funds in fixed deposit schemes.

The Union Budget has proposed to hike the DDT on money market and liquid mutual funds to 25 per cent from 12.5 per cent for retail investors and 22.5 per cent for institutional investors.

The DDT also faces additional surcharge and educational cess, which would now take the total taxation for both types of investors to 28 per cent.

Liquid funds are primarily used as alternative short-term fix deposits, where most of the money is put into liquid debt instruments "" those which could be redeemed easily.

These funds are preferred by corporates and high net worth investors, as highest tax bracket investors use this mode for arbitrage opportunity owing to lower taxation. Retail participation in these funds is minuscule.

However, the mutual fund industry thinks that the move may not mean to be a setback for fund houses, as more than 90 per cent of their liquid fund investments come from corporates, which already pay a total of 26 per cent DDT and they now face added taxation of around 2 per cent (including the surcharge).

"A corporate entity belonging to the top tax bracket, which invests into one-year bank deposits, normally draws around 6-6.5 per cent, is exposed to 33 per cent taxation on returns. However, if this money put into liquid funds, it is charged a total taxation of around 25-26 per cent. Now, with increase in the DDT, this benefit has been reduced. However, considering the flexibility funds offer, it's still an attractive option against the bank deposits," Devendra Nevgi of Quantum Mutual Fund said.

Banks are currently offering from 6.5 per cent up to 9 per cent interest for deposits with one-year maturity and more, as an effect of the Reserve Bank of India's (RBI) decision to harden interest rates.

The budgetary proposal would make bank deposits more attractive, as since the last year, liquid funds have given average returns of up to 6-6.5 per cent, which is at par with the bank's offering for one year maturity deposits.

"Investments coming to these funds are aimed more at parking funds for a better return than other instruments and ensuring that the funds would be redeemed at any point. Bank deposit rates are up, but it lacks the flexibility benefit," a debt fund manager said.