Proposed tax rejig may trigger outflow from debt MFs into equity: Analysts

The proposed changes in the Finance Bill that seek to do away with the indexation benefit on debt mutual funds and treat them at par with bank deposits (FDs) are negative for the MF industry, and could see investors flock to equities, suggest analysts.

The proposed amendment will also affect gold funds and international funds, analysts said, who believe that bank FDs will become more attractive as both – debt funds and bank FDs – will be subject to the same taxability of maturity proceeds. The proposed changes are likely to be implemented from the new fiscal year (2023-24) starting April 01 as the Parliament has apporved amendments to Finane Bill, 2023.

The proposal if implemented, according to said Manish. P Hingar, Founder at Fintoo, a robo advisory firm, may have a negative impact on all debt funds, particularly in the retail category, as ultra-high net worth and high net worth individuals may choose to invest in safe havens like bank FDs.

"We may see a shift from long-term debt funds to equity funds, and money may be directed towards sovereign gold bonds, bank FDs, and non-convertible debentures in the debt category. This is good news for banks as they can attract customers with higher interest rates and increase their borrowing and saving book sizes," he said.

Liquid MFs of Rs 6.6 trillion, said analysts at CLSA, will not be impacted materially as they are anyways a short-term product and there is no material change in tax attractiveness. The development, they said, is marginally positive for bank credit / deposits. The MF industry, they estimate, has non-liquid debt assets under management (AUMs) of around Rs 8 trillion (19 per cent of AUMs).

"For AMCs under our coverage, revenue contribution from non-liquid debt products is 11-14 per cent. We believe this is moderate to low impact as bulk of the revenue/profitability for AMCs accrues from equity AUMs and non-liquid debt AUMs are neither higher growth nor higher profitability segments," wrote Adarsh Parasrampuria of CLSA in a coauthored note with Mohit Surana, Piran Engineer and Shreya Shivani.

Currently, all gains arising from debt fund investments of over three years are taxed as long-term capital gains (LTCG) at the rate of 20 per cent with indexation benefits, or 10 per cent without indexation. Return on investments of less than three years, on the other hand, qualify for short-term gains tax (STCG), where the investor has to pay tax at his slab rate.

"The development is negative and can see money move out of debt funds. This is a structural change. That said, it is a bit premature to say anything with certainty. If the proposals are implemented, the flows in debt mutual funds could suffer. If there is a significant variation in the risk-return paradigm, then the asset allocation models itself might change," said a senior fund manager with a mutual fund.

According to the proposed amendment, debt funds with less than or equal to 35 per cent invested in equity shares will be taxed at the investors' income tax slab and treated as STCG. This is akin to how bank deposits are taxed. That apart, debt mutual fund investments will also not allow indexation from April 1 in the above-mentioned case.

"This is a welcome move from the equities / equity funds perspective, as investors may opt for equity mutual funds, increase allocation to equity MFs via the systematic investment plan (SIP) route, or even invest directly instead of opting for debt MFs in the backdrop of the tax-related changes. It is advisable to take some risk and invest in equities instead of debt MFs," said G Chokkalingam, founder and head of research at Equinomics Research.