The withdrawal of India’s capital gains tax benefit on debt mutual funds
is significant for various reasons. The first is that it seems aimed at the
country’s overall goal of a tax structure that is simple, with few exemptions
and benefits. Second, following from the first, it indicates that over the next
few years, just as all debt is taxed in a similar manner, equity sops may also
end. Already dividends are taxed at the slab rate and no capital gains are
tax-free. The ₹1 lakh limit may also go at some
point. Third, while the market absorbs these announcements, it should be
prepared for further such changes that withdraw tax benefits. Alternative
structures are presently being offered for income tax and corporate tax. One
may expect convergence in the next few years.
Is this a good move? For the government, it is evidently good as tax
revenue increases, which is what it needs, given that today’s structure offers
limited buoyancy. The economy is stuck in a 6-8% growth band and a 10% rate
that can generate more revenue looks like a long journey. Therefore it is a
winning situation, as returns on savings held in debt will draw slab-rate
revenue.
For mutual funds, this is a setback because debt funds account for
around a third of total assets under management (AUM). So the withdrawal of a
tax benefit that is probably their main allure will mean a shift of funds away
to either equity/hybrid schemes or fixed deposits and directly bought bonds.
Even within debt funds, schemes loaded with, say, government securities had
been giving lower returns of 6-7% but looked better with the tax benefit. In
fact, an anomaly was that if one purchased corporate bonds giving an 8% return,
the interest earned was taxed at the slab rate. However, in the hands of a
mutual fund, after adjusting for fund expenses, one could pay just 20% tax on
an indexed value if held for at least three years.
For individuals, this is a big blow. The only balm applied is that it
would hold for investments made post 1 April 2023, unlike the last time when
the ‘long term’ definition was changed from 1 to 3 years where it was imposed
retrospectively. Logically, if the government earns higher tax revenue, it has
to be paid by unit holders, whether corporates or retail investors. As the
economy has been hit with relentless inflation of 6% plus for three successive
years, the capital gains sop helped to partly protect returns. Form now
onwards, this benefit disappears.
Banks and NBFCs would be better off now. In fact, they had been arguing
for the same capital gains benefit on deposits kept for 3 years and above as
was the case with debt mutual funds. Now a level playing field has been
provided, as that benefit has been altogether abolished. More funds are likely
to flow into deposits now; and after assessing the situation, banks could also
lower their rates as there are no risk-free alternatives for savers.
That said, the biggest blow is for India’s corporate bond market. There
have been several attempts made to grow this market by the government, Sebi and
RBI. Now two things will push the market back significantly. First, the ability
of mutual funds to invest is limited by final investors opting for such
schemes. If they migrate away from them, then demand for corporate debt will
come down.
Second, at the retail level, this move is quite detrimental. Individuals
as a rule should not get directly into the debt market because it is hard to
understand the dynamics of bonds. Unlike equity, where a company’s share is
easy to identify and hence buy and sell, bonds pose challenges. Bonds have a
coupon rate and a tenure, and as time elapses, their implicit yield is hard to
grasp. Besides, there is not much trading that takes place for most, which means
they cannot be bought and sold easily.
Presently, investors buy units of a mutual fund scheme which in turn
invests the money. Now with their net returns coming down sharply, it does not
make sense to invest in debt funds. While RBI has been trying to get retail
investors to invest directly in government securities, it made more sense for
people to invest through a mutual fund window, not just for returns but also
access to liquidity. Now, one has to think hard before entering this market, as
it is not easy to sell securities that do not trade on a daily basis.
The setback to India’s market for corporate bonds is probably the most
significant impact of this latest move. Companies with a lower rating of, say
‘A’, which could hope to attract mutual fund money, will now find it harder to
find investors. At the retail level, there is risk aversion for lower-rated
bonds. The ability of mutual funds to invest in debt depends on how savers
deploy their funds. While corporates would still consider such deployment,
retail investment, which accounts for 55-60% of the sector’s total AUM, would
surely draw back from the debt segment.
Given the way in which Indian tax laws have evolved over the past 10
years, one could see the change announced on 24 March coming. Equity market
gains would also be taxed at the slab rate once the logic of a level playing
field comes to determine tax policy. The rationale offered would be that
providing equity-gain sops has not moved the needle of private investment.
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