Debt Mutual Fund Is Not An FD, Has Underlying Risks. Hence, It Requires Tax Benefits Like Equity Does

No new investors are expected to switch to debt mutual funds from fixed deposits hereafter.

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In a surprising move, debt mutual fund (DMF) taxation laws were changed abruptly as the Narendra Modi government amended the Finance Bill 2023. These new rules treat DMF at par with fixed deposits (FD) and will now be taxed at the individual’s marginal rate of taxation from April 1, 2023. The banking industry had been lobbying for this for years. 

The DMF industry fears incremental flows in medium- to long-term into DMFs might get impacted due to this change. No new investors are expected to switch to debt mutual funds from fixed deposits hereafter.

Currently, any capital gain on redemption of a debt fund held for three years or longer is treated as long-term capital gain and is taxed at a flat 20 percent with indexation benefit. 

Any capital gain on redemption before three years is treated as short-term capital gain and is taxed at an individual’s income tax slab rate. This made DMF attractive from a post-tax returns option for long-term investors compared to FDs and bonds. Interest income from FDs and bonds is taxed at an individual’s tax slab rate.

Justifying the move, Finance Secretary TV Somanathan said: “There should be parity between various debt instruments. Income that is being earned as interest needs to be taxed.”

A DMF’s Net Asset Value (NAV) is a combination of interest / coupon on the debt instruments and changes in the price of the underlying debt instrument based on the interest rate movements. So the premise that a DMF is only an interest / coupon bearing investment vehicle and hence should be taxed in a similar manner like FD is incorrect in our opinion. 

Interestingly, an equity share also has dividend as an embedded value. But dividend on equity is taxed at a higher rate than the capital gains tax on equity.  So why not the same differentiation with debt can continue to exist? An FD enjoys a deposit insurance. Other debt instruments do not have that luxury. 

Importantly, when there is negative news about a listed entity, an equity investor gets a chance to sell his holding even if the price falls. However, a debt instrument holder may not get a similar chance even if the instrument is listed. 

Yes Bank's perpetual bonds were completely written off and these bond holders have not received anything. Its equity price did not reach zero levels and holders of shares got some value. 

In case there is a delay in interest payment or a downgrade in credit rating of an issuer, the NAV of DMF scheme which owns such instruments falls. This was reflected with a cluster of Franklin Templeton schemes couple of years back. Given the extent of defaults in the banking system — NPA, NCLT, IBC cases — debt is increasingly becoming riskier. 

For the record, the value of equity held by retail investors is Rs 20 lakh crore while the Gross NPA of the banking system is Rs 10 lakh crore. This is after writing off Rs 11.2 lakh crore worth of loans in the last six years alone.  

What Is More Risky? Debt Or Equity?

This is a big debate, but with no clear answers.

To make matters worse, equity investors have a shorter tenure for determining capital gain (and lower tax rate too compared debt) when it is often believed to be a longer duration asset class. While debt being fundamentally a shorter gestation asset but has a longer duration with reference to capital gain calculation, and now have to pay higher tax too.  

If equities enjoy tax sops because of being a riskier asset class then DMF should also have similar benefits. 

As per AMFI, of the Rs 17 lakh crores of non-equity MF subscriptions, 62% is by corporates and banks. Also, more than 80% of this category of investors stays invested for less than 24 months. So, most of the large and big investors stay invested in non-equity MFs for less than 24 months. 

However, close to 60% of retail investors stay invested for the the longest period (24+ months). On one hand, the Reserve Bank of India (RBI) wants to increase retail participation in debt markets, but on other hand it has done away with taxation / indexation benefit for the retail investors.

If the Government of India wishes to stop large corporates, HNIs, family offices etc from taking undue advantage by investing in DMFs, taxing aggregate DMF holdings of an individual could have been a better option with a ceiling of say Rs 2 crore. Something similar was done with reference to real estate in the recent budget.

This step is likely to reduce further retail participation. FDs also carry a risk as deposits up to only Rs 5 lakh is insured. In case of any emergency, if there is a problem with the bank, like it happened with PMC, SVB and others, there tends to be a cap on withdrawal. So weaning away entirely from DMF towards FD is not the correct strategy.

DMFs are a large source of funding for NBFCs (less than AAA rated). These NBFCs would now have to increase their FD rates to attract depositors, which could further expose retail investors to both credit quality and concentration risks.

Overall, the withdrawal of indexation on DMF need to be reconsidered as, from a structural perspective, it could cause more harm rather than yielding benefits. 

Amitabh Tiwari and K. Shankar are registered investment advisors with SEBI.

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