Change in debt mutual fund tax norms could channel flows into bank FDs, say experts

“If the proposed amendment is approved, debt funds will lose  the indexation benefit. HNI, ultra-HNI, and institutional money is invested in these funds, which may be diverted to bank deposits,” said Suresh Kishinchand Khatanhar, Deputy Managing Director, IDBI Bank.

“More money will move to bank FDs. With the removal of lower taxation per long-term capital gains (LTCG) rates on debt investments, debt funds and bank FDs will be taxed alike. This is advantageous for bank FDs as bank FD interest rates are moving up now,” said Dr VK Vijayakymar, Chief Investment Strategist, Geojit Financial Services.

“This sudden move seems to be aligning the taxation of these debt products in line with bank FDs. This is positive for all bank FD schemes,” said Venkatakrishnan Srinivasan, Founder and Managing Partner, Rockfort Fincorp.

While income tax needs to be paid on bank FDs every year, in case of debt funds it has to be paid on redemption.  However, investors may have to pay brokerage and other incidental charges in case of debt MFs.

Also Read: Indexation benefits on debt funds will go away now

What are the proposed amendments?

Earlier today, the Lok Sabha on March 24 passed the Finance Bill 2023 with amendments.

The Finance Bill, which contains proposals related to taxation and government spending, was passed with several amendments. Besides, 20 more sections were added to the Bill.

The bill proposes that income from investments in MFs where not more than 35 percent is invested in stocks of Indian companies, i.e., debt funds, will now be considered short-term capital gains.

That is, capital gains from debt funds, international funds, and gold funds, irrespective of their holding period, will be taxed per an individual’s relevant tax slab. Income from bank FDs are also taxed the same way.

Prior to this, if held for more than three years, debt funds were taxed at 20 percent along with indexation benefits, or at 10 percent without indexation. If held for less than three years, the gains were taxed per one’s tax slab.

“Debt mutual funds had a significant tax advantage in the debt space, which will go away post the amendment in the tax laws. With this, debt funds and bank FDs will have similar tax rates and hence it will be more or less a level playing field as far as taxation goes,” said Rajeev Thakkar, CIO and Director, PPFAS Mutual Fund.

Dying for deposits

The move has come at a time when banks are struggling to increase their deposits to match the lending growth in the system.

In order to attract more deposits to keep up with the credit growth, banks are offering higher interest rates.

FD rates have risen since the Reserve Bank of India (RBI) increased the repo rate – at which it lends to banks – by 250 basis points since May 2022 to fight soaring inflation.

Also Read: Not just debt funds – gold and international funds to also lose from Finance Bill amendment

Exit load on FD and debt funds

FDs have a fixed term and if an investor breaks it earlier then they have to pay a foreclosure penalty.

However, generally in debt fund schemes there is no exit load, and investors can exit anytime.

Sanjay Pawar, Fund Manager, Fixed Income, at LIC Mutual Fund Asset Management, said an investor may see capital appreciation in case of mutual funds, however, this will not be possible in case of bank FDs.

Impact on bond market

The bond market is unlikely to be impacted by the proposed taxation of debt funds because the overall flows are expected to remain the same in the system.

“Some HNIs may explore other alternatives, while some may choose to keep investing in mutual funds. The impact on debt markets is expected to be minimal as the overall money supply in the system will remain the same,” Thakkar said.

After this announcement, the bond market has not reacted much and remained mostly range bound. The 10-year benchmark 7.26 percent 2032 bond yield opened at 7.3255 percent, and closed at 7.3128 percent.

Some dealers feel the new norms are going to be positive for the debt market as plain vanilla bonds, debentures, and fixed deposits will become more attractive options for retail, HNI, and family office investors.

“Although this may seem like a setback for the debt mutual fund market, we see it as a positive change for other fixed income assets,” said Vibhor Mittal, Group Chief Risk Officer, YubiInvest.