Budget 2024 and mutual funds: Industry hopes for debt taxation relief, parity with ULIPs

India's mutual fund industry, which crossed Rs 50 lakh crore in assets under management (AUM) last month, has an AUM-to-GDP (gross domestic product) ratio of around 15 percent currently, which used to be 7-8 percent, a decade ago. The ratio represents the penetration of mutual funds in India. Experts say more efforts are needed on the part of the government to push this ratio higher.

Debt taxation rollback

According to the amendments to the Finance Bill on March 24, 2023, gains from funds with less than 35 percent of their assets in equities do not offer long-term capital gains tax and indexation benefits. Irrespective of when you sell these units, they are added to your income and taxed at your income-tax rates.

Earlier, gains from investments in debt funds – if units were held for more than three years – were subject to the long-term capital gains (LTCG) tax rate of 20 percent, after indexation.

According to experts, this has impacted the appeal of debt funds to an extent. "Post the debt taxation changes, inflows into fixed-income mutual funds have slowed down. A lot of investors look at mutual funds for safety. Some of the actively managed debt funds such as duration products or dynamic bond funds are good instruments. They should be given some benefit of indexation. That will help some of the products on the debt side to again get back investment interest," said Mahesh Patil, Chief Investment Officer (CIO) at Aditya Birla Sun Life AMC.

Partial relief

The aim to tax debt funds had a ripple effect on some other categories as well. The taxation change has meant that gold funds, international funds, funds of funds – any product which invests less than 35 percent in Indian equities – have also been hit.

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Jimmy Patel, Managing Director and Chief Executive Officer, Quantum AMC, believes that the government should revise the definition of equity-oriented mutual fund schemes by including equity Fund of Funds (FoF) schemes.

"At present, even an equity FoF is regarded as debt-oriented from a tax standpoint. I see no logic in this. An equity FoF should be on par with equity-oriented mutual funds for taxation," Patel said. Fund of funds are mutual fund schemes that invest in the units of other schemes of the same mutual fund or other mutual funds.

More tax efficient

For deeper penetration of mutual funds, experts along with investor education, the government should consider making such investments more tax efficient.

In this regard, Patel suggests, "The Budget should address the difference in tax treatment between equity mutual funds and ULIPs (Unit-Linked Insurance Plans). At present, when it comes to capital gains of ULIPs, if the annual premium is less than Rs 2.5 lakh, the returns are not taxed. It is important to bring both ULIP and equity mutual funds on par as regards taxation, since ULIPs are essentially investment products providing some risk cover."

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To make mutual funds more tax efficient, the government can also make switching of investment within the same scheme of a mutual fund, or intra-scheme switches exempt from payment of capital gains tax as no gains are realised in such a case.

"Amendments must be made so that switching of units from (a) regular plan to direct plan or vice-versa; and (b) growth option to dividend option or vice-versa, within the same scheme of a mutual fund are not regarded as 'transfer' and hence, shall not be charged to capital gains. Also, I would go one step further and propose that when an investor moves or switches his or her investment from one equity scheme to another equity scheme within the fund house, the government should consider exempting the capital gains, since it's a case of simple allocation of the funds," Patel added.

Status quo

Note that since it is an interim Budget, or a vote on account, before the Lok Sabha elections 2024, there may not be many changes in the finance bill to be presented on February 1.

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"While no big-bang announcements are expected in the interim Budget, we expect the thrust toward infrastructure spending and manufacturing PLIs (Production Linked Incentive Scheme) to continue in the full Budget announcement later in the year. Given the sharp run-up in markets, especially in midcap and smallcap spaces, investors are advised to focus on asset allocation and invest with realistic return expectations. Don't invest purely basis the superlative returns in recent years," said Kaustubh Belapurkar, Director-Manager Research, Morningstar Investment Research India.