Debt Funds & Bank deposits---What now?

The Finance Bill (2) 2014-15 was passed by the Lok Sabha on July 25, 2014.  There has been an amendment that impacts debt mutual fund investors. Non-equity oriented mutual funds, which were redeemed in the period April 1 to July 10, 2014 will be eligible for tax concessions available before the budget was announced.

Interpretation

1. All redemptions, STP, SWP and switches made from FMPs, debt funds, MIPs, gold funds and ETFs and international funds, before July 10, 2014 will enjoy the benefits that existed earlier. The holding period to classify gains as long term will be 12 months, and taxation at 10% before indexation will be available for these transactions

2. Any of the transactions as above, made after July 10, 2014 will be subject to the new rules. The holding period for treatment as long-term capital gains will be 36 months. These will be taxed at 20% after indexation. Any gains for holding periods less than that will be treated as short term capital gains, and taxed at the marginal rate applicable to the investor.

Implications

1. Capital gains accrue on sale of an asset. Therefore the new rules will apply at the time of redemption of units. There is no concession on purchases made before July 10, 2014. FMPs with maturity less than 3 years and non-equity oriented funds irrespective of when they were bought, will be subject to the new rules if they are sold within 3 years, after July 10, 2014.

2. Mutual fund investors can approve changes to the fundamental attributes of a scheme. Mutual funds are now sending investors such consent letters, to extend the maturity of shorter term FMPs to a period of 36 months plus 1 day.  Investors, who do not sign and return such consent letters, will receive the redemption of units on the original maturity date.

3. Investors can consent to a change in scheme features such as applicability of exit load, extension of maturity date, or change in the type of fund from closed end to open ended.

4. Investors whose marginal rate of tax is nil are not impacted by this change. Retired investors, whose income falls below the exempt limit for taxation, have a marginal rate of taxation of ‘nil’.  Therefore such investors are free to redeem, switch or continue with their SWP or STP as before.

5. Investors who have set up SWP or STP from their debt mutual funds will be impacted, but not as much as feared. Each withdrawal will be subject to tax, based on the first-in-first-out principle. Until the time difference between the investment and withdrawal is more than 36 months, they will be subject to short-term capital gains tax.  But SWP or STP or redemption from a growth option will include capital and income (recall that NAV represents both). Therefore the impact will be far lesser than the tax impact on interest from bank deposit

This difference is because the entire bank interest earned is treated as interest income, but a large part of redemption of the mutual fund is treated as withdrawal of capital invested. Only the gain is subject to tax in a mutual fund, whereas the entire interest income from a bank deposit is subject to tax.  Unless the investor redeems the entire amount invested, as may be the case in an FMP, the tax treatment as capital gains (short or long) will work in favour of investments in mutual funds. 

Date	Investment Value	NAV	SWP/STP	Balance Units	Capital Gains	Tax @ 30%
01/04/2014	3000000.00	10.000	0	300000	0	0
01/05/2014	3024999.00	10.083	300000	270247.92	2479.240	743.77
01/06/2014	2747706.42	10.167	300000	240741.56	4936.413	1480.92
01/07/2014	2468103.15	10.252	300000	211479.366	7376.424	2212.927
01/08/2014	2186169.96	10.338	300000	182458.836	9794.705	2938.412
01/09/2014	1901887.41	10.424	300000	153678.136	12193.00	3657.90
01/10/2014	1615235.94	10.511	300000	125135.284	14571.48	4371.44
01/11/2014	1326195.80	10.598	300000	96828.314	16930.30	5079.09
01/12/2014	1034747.09	10.686	300000	68755.276	19269.26	5780.89
01/01/2015	740869.74	10.775	300000	40914.238	21589.62	6476.885
01/02/2015	444543.51	10.865	300000	13303.281	23890.44	7167.13
01/03/2015	145747.99	10.956	145747.99		12715.17	3814.55
TOTAL WITHDRAWAL			3145747.99
CAPITAL GAINS ON WITHDRAWAL			43724.40			43724.40

This is a bit more detailed and assumes a 0.0833% return per month (10%/12 months) and the increase in NAV reflects that. The SWP is constant, until it falls below the value of Rs.3 lakh and is fully redeemed. The result will not alter unless the SWP is extended beyond 36 months. The investment value is balance units times NAV; balance units is after reducing units amounting to (STP amount/NAV); and capital gains are redemption value less cost of redeemed units.  

When one invests Rs. 30 lakh in a debt fund (first line) and begins an STP, the withdrawal does not get fully taxed, as is the case with a bank deposit. That is because each withdrawal has one portion as capital and one portion as income. Only a part of it is capital gain, and will be taxed.  Recall that I also wrote that taxation will be on first in first out basis. This means, as the investor draws money over time, the cost remains Rs. 10 per unit, but as the NAV grows the gain grows.  The sum total of capital gains tax, when the entire amount is withdrawn (last row) is the same as if the total of invested amount plus gain was withdrawn in one lump sum.  The small amounts of capital gains tax will grow, and add up, such that the gains from SWP/STP equal the gain from a lump sum income as in a bank deposit. There is no real tax advantage in a debt fund, if the withdrawal is before 36 months.

  

To those that still refuse to give up, there are two options:

1. If the first SWP is after a lapse of a period of 36 months, the indexation benefit will kick in.

2. If the investor does not redeem the entire amount, and if the SWPs spill over into a period   greater than 36 months, there will be a benefit of lower taxes for those SWPs

The summary therefore is, for all redemptions from a debt fund (SWP, STP, switch, maturity) which happen before a period of 36 months, the amount of tax an investor will pay is the marginal rate applicable to the investor. 

It is time to give up the tax arbitrage and focus on the real merit. The access to debt markets, the lower risk of a portfolio, the lower cost compared to a high spread of other intermediaries, the benefit of total return from marking to market, the flexibility of easy investment and withdrawal, and the professional management of credit and interest rate risks are all significant merits to invest in a debt fund. 

(Courtesy: - www.ciel.co.in)