There was huge cry and discussion going on in all platforms of planners that Budget 2014 will impact Debt Fund investors or FMP investors. I tried to wait till I get clarity from all angel to write on the same. Now some clear picture is emerging, so thought to share with you all.
Do you know how big is Debt Mutual Fund Industry in India? Please have a look at below chart which explains the % of AUM spread across asset classes (AMFI data as on 30th June 2014). This shows the impact these tax changes will have on this industry.
Mainly there are three changes which were introduced in Budget 2014 and they are as follow.
1) Holding Period
Before budget holding period for Long Term Capital Gain (LTCG) for Debt funds was 1 Year. So if you withdraw within a year then it is considered as Short Term Capital Gain (STCG) and more than a year then it is treated as Long Term Capital Gain (LTCG).
But now this changed to 3 years. Means according to current taxation rules, holding period less than 3 years is considered as STCG and more than 3 years is LTCG.
2) Indexation Benefit
Earlier if your holding period was more than 1 year then you have option to pay tax either flat at 10% OR with indexation at 20%. Now according to current rule you need to pay tax for LTCG with indexation at 20%.
Let us take an example of how above said change affect investors. Suppose you are investing Rs.100 in Bank FDs and Debt Funds for 1 yr and return on Bank FD and Debt Fund is 10%. How the change will impact?
You notice that there is no change in Bank FDs and Debt Funds if your time period is less than three years. Also notice the post tax return difference existed earlier. That is the reason Debt Funds were heaven for highest tax bracket individuals and companies to park their short term funds. But after this budget such opportunity lost
Note-Effective date of these changes is yet a confusing. Because few claiming it to be from 1st April 2014, few after budget date and few claiming it to be from next year.
As debt fund returns are not guaranteed compare to Bank FDs, now we may notice flow of funds from these debt funds to Bank FDs in near future.
Funds that affected with these new changes-
- Debt Funds
- Gold Funds
- Fund of Funds
- Non equity Infra Funds
- Any fund whose equity exposure is less than 65%
3) Dividend Distribution Tax (DDT) Method
Dividend distribution tax is something which mutual fund companies used to pay but not investors. So in investors hand it is tax free and will continue as usual. Rate of DDT was not changed and it will continue as usual at 25%+10% Surchage+3% education cess. But due to change in method calculating the tax, investors will receive less dividend than earlier. Let us take an example on this.
Suppose mutual fund company have Rs.100 as distributable income. Then let us see how the calculation method changes and how it impact effective dividend distribution tax from below excel prepared by Mr.Pattu
You notice that earlier if distributable income is Rs.100 and mutual fund company planned to distribute Rs.80 then the tax will be only on Rs.80 but not on whole Rs.100. But now onward it is on Rs.100 with this effective dividend distribution tax raised from existing 20% to 25% (excluding surcharge and cess). Hence from now onward there is no meaning for “Effective Dividend Distribution Tax”. Because both DDT and EDDT are equal i.e at 25%
But individuals who fall at 30% tax bracket still have advantage of dividend option. Because on Bank FDs they need to pay the tax at 30% where as in case of dividend option of debt mutual funds they paying 28.325% (including surcharge and cess).
So what is total impact on you as an investor of Debt Funds?
From now onward anything less than 3 years investment will be good if you go for Bank FDs. But if you have time horizon of more than 3 years then debt funds still hold edge irrespective of your tax slab. For a detailed comparison on Bank FDs and Debt Fund you can view Mr.Pattu’s post.
What about Direct Bond Investments?
Any listed bond including zero coupon bonds will enjoy the old capital gain rules. Means holding period less than year is treated as STCG and more than year is LTCG.