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Dead End For Debt Funds?

Author: Shivram Yedithi/Friday, August 1, 2014/Categories: Mutual Funds, Invest

Dead End For Debt Funds?

Has the finance minister in the union Budget jeopardized the major chunk of mutual fund AUM by tweaking the long-term capital gain period and the way the Dividend Distribution Tax is calculated and executed? Firstly, let’s look at the impact of change in applicability of long term capital gains from one year to three years and long term capital gain tax at 20% instead of earlier 10%.

Although when people talk about mutual fund it is mostly equity funds, it is surprising to see the contribution of debt funds to the mutual fund industry. Debt at this point stands at 68% of the entire industry AUM which is at Rs 9.85 lakh crore. So, the contribution of debt fund is at around Rs 6.65 lakh crore. The new change will not only affect the debt funds but also other schemes where taxation is of debt. So, this will expand it further to few hybrid schemes (which have less than 65% equity) such as MIP, Multi Asset funds and also Commodity funds.

In effect, it will have its impact on almost three fourths of the AUM. However, liquid and ultra short term funds which are utilised for short term parking of funds might not have much of the impact. This category of funds contributes approximately Rs 3.33 lakh crore.

The question remains why the changes should affect the mutual fund AUM at all. All the while when somebody invested in the debt, it has been compared with what fixed deposits could offer. The difference was evident when it came to the taxation part. Although, the returns by fixed deposit is fixed while in mutual fund it is volatile, but still the taxation made it a very attractive option. Earlier any investment in debt held for more than a year was treated as a long term capital gains and investor had a choice to pay flat 10% or apply indexation and gains arising out of the inflation adjusted investment amount (based on the cost inflation index figures released by the Ministry of Finance) were taxed at 20% irrespective of the tax bracket an investor falls in. This made the investment an attractive option for those in higher tax brackets or even for lower tax brackets as indexation erased most of the gains due to high inflationary environment.

Now with new guidelines for debt funds, the gains will be classified as long term capital gains if held for more than three year period and also, the long term capital gains will be taxed at 20% instead of earlier 10%. Also, there is no mention on the applicability of indexation, which at least would have been saver as it would have meant virtually no gains since the period for consideration of inflation is three years. What this means is, the gains which earlier used to be long term capital gains will now be a part of short term capital gains which will be taxed as per the tax bracket of the investor.

Let us look at this with an example to see how the returns will get affected by the new guidelines. If an investor had invested Rs 10 lakh in a debt fund in October 2011 and has redeemed Rs 13 lakh on 30th Jun’14, the CAGR returns comes to be 10.02%. Let’s see now the difference in returns by applying the old as well as new guidelines.

In earlier case, qualified under LTCG, the capital gains (without indexation) would have been Rs 3 lakh and the LTCG tax (without indexation) would have been Rs 30,900 — a post-tax returns of Rs 2,69,100 and post-tax ROI of 9.06%. The Long Term Capital Gain Tax (with Indexation) would have been zero, post tax returns Rs 3 lakh, and post tax ROI Rs 10.02%.

However, now as per the new guidelines the returns for investors in 30%, 20% and 10% tax bracket would be like this (See How Your Capital Gains Has Changed).

This leads us to a situation whereby it becomes really difficult to differentiate between fixed deposits from debt funds. Still, there is a difference in terms of capability of generating returns higher than fixed deposits, which however is not certain and for sure not fixed. If you look at the maximum returns generated in the most popular category of debt schemes, the idea of looking at the debt funds over fixed deposits stand firm and it reiterates the fact that these debt funds certainly have the potential to deliver returns well above what fixed deposits can offer.

Now, with debt funds supposedly loosing sheen, people might start looking at fixed deposits over debt funds. This in turn might lead to lowering of deposit rates, as it is generally done to attract investors to deposit money which is used for lending purposes by the bank. This situation will put investors in a fix whether to invest in debt funds looking for better returns or stick to fixed deposits even if they lower the rates. What needs to be seen now is whether the proposed changes are accepted in full and what will be the date of effect.

Coming to second part of the proposed change is the Dividend Distribution Tax to be applied on the gross dividend and not on the dividend paid. Let us look at how the calculation of dividend will be changed. For example, a scheme has declared Rs 100 as dividend and Dividend Distribution Tax for Individual is 28.325%. Dividend Payout according to previous method was like this: dividend declared Rs 100, DDT rate 28.33%, dividend payout 77.93 (100/ (100%+28.33%), effective rate 22.07%.

Dividend payout according to new method is like this: dividend declared Rs 100, DDT Rate 28.33%, dividend payout 71.68 (100*(100%-28.33%), effective rate 28.33%. This in effect reduces the arbitrage opportunity for someone in 30% tax bracket from 8.53% (30.60%-22.07%) to 2.28% (30.60%-28.33%).

How does this actually work? Most of the schemes offer dividend option and many investors prefer as the dividends are tax-free in the hands of the investor. The change in the calculation will reduce the payout amount in case of dividends, as earlier tax was calculated on the dividend paid and now the revised guideline says the tax has to be applied on gross dividend.

This will have impact on the short term schemes where the investment is done with short term horizon, for example liquid or ultra short term funds where the unutilized funds are parked for short term. Also, to get the tax arbitrage companies and high net worth individuals falling higher tax bracket preferred dividend option. To suit the investor preferences, schemes as well offer daily, weekly and monthly dividend option, wherein almost most of the gains are paid out in the form of dividends.

Let us look at a case where the investor has invested Rs 10 lakh in a liquid fund and has been paid the entire appreciation with return on investment at 9% p.a. over the three month period in the form of dividend. Let us look at how the change in DDT would have impacted his returns (See Change In DDT: How It Impacts You).

The difference in return is approximately 0.56%.

In the same case if investor would have invested in a growth option instead of dividend, the gains would have been taxed as per the tax bracket, so the effective returns in such case would be: redeemed sum after 3 months 10,22,500, gains Rs 22,500, STCG tax for 30% tax bracket Rs 6,952.50, effective returns for investors in 30% tax bracket 6.22%. The change in returns is approximately 0.23%.

However, for someone in lower tax brackets the returns will be significantly higher. For instance, for a person in 20% tax bracket the post-tax returns would be 7.15% while for a person in 10% tax bracket the post-tax returns would be 8.07%.

This shows that the changes applicable will have major impact over the higher tax bracket individuals and for someone in the lower tax brackets will be in a better position if opted for growth option rather than dividend option in case of debt schemes.

The applicability of the proposed changes is being discussed and the date of effect of these changes will be announced soon. The points discussed are the effects the changes will have if incorporated in full without any changes.

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