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Many ways to rejig Debt MFs post-budget

As you may be aware, budget 2014-15 has removed the tax arbitrage enjoyed by debt mutual funds vis-à-vis fixed deposits and such other debt investments.

Earlier, debt mutual funds (or rather, more specifically, all non-equity oriented mutual funds) were
i)  classified as long term capital assets if held for more than a year and
ii) such long term capital gains were taxed at 10% (without indexation) or 20% (with indexation).

Comparatively, interest income on fixed deposits, being taxed as per investor’s marginal tax rate, was tax-inefficient for investors in the 20% or 30% tax brackets.

However, pursuant to the changes announced in the Finance Bill 2014-15, w.e.f. July 10, 2014,
a) Debt and other non-equity oriented mutual funds would be classified as long term capital assets only if the period of holding is more than 3 years as against 1 year till now.
b) In addition, the concessional tax rate of 10% (without indexation) will not apply to these funds. Instead, they would be liable to pay 20% (with indexation) long term capital gains tax.
c) Investments up to 3 years would now classify as short term capital gains and taxed as per the investor’s marginal tax rate.

This has two serious implications
1. Those who invested in debt MFs in past thinking that they would enjoy both concessional time-frame and tax are now liable to much higher tax
2. Going forward, it is a massive opportunity loss for investors seeking safe and tax efficient investment for a period of 1 to 3 years.

Not to worry. There are solutions to this problem.

A. Those invested in open-ended debt mutual funds can consider extending the holding period to 3 years wherever feasible. With 3 years of indexation benefit, the actual tax liability would be minimal. Hence, long term debt investors are not likely to be much affected by this amendment.

B. Those invested in 1-3 year close-ended Fixed Maturity Plans (FMPs) are being offered an opportunity by the mutual fund companies to roll over their investment. This would enable the investment to complete the desired 3-year period and enjoy much lower taxation. 

C. Those looking for fresh investment can consider equity-oriented Arbitrage Funds if the time horizon is less than 3 years. For period less than a year, arbitrage funds are taxed at 15%. And for period exceeding one year the tax liability is Nil. [As I have explained earlier, arbitrage funds are designed to offer safe debt-like returns despite the exposure to equity.]

NOTE: Even though for period 1-3 years, the tax advantage vis-a-vis FDs is lost, allied benefits — i.e. flexibility to withdraw anytime without any penalty (except for exit load till a minimum specified period) and no cumbersome TDS — still tilt the scales in favour of debt MFs.

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