In this article, we explain why investors and AMCs need SEBI’s help in tackling the debt fund taxation rule to come into force from 1st April 2023.
Taxation status from 1st April 2023
- Funds holding 65% or more of Indian equity or Indian equity ETFs are equity funds (no change in this)
- Funds holdings less than 65% Indian equity but more than 35% Indian equity are non-equity funds (we will refer to these as class I). Gains from units purchased on or before 3Y are short-term gains and taxed as per slab, and gains from older units are taxed at 20% with indexation (no change in this).
- The big change: Funds holding less than or equal to 35% equity will be taxed as per slab regardless of the age of the unit. Let us call these class II non-equity funds. This will only apply to fresh purchases made from 1st April 2023.
- This will also affect all international equity funds and gold funds.
Many non-equity funds must change their investment mandate to keep the AUM flowing. However, the SEBI categorization rules have many restrictions in place.
Take, for example, Parag Parikh Conservative Hybrid Fund. This is now mandated to hold only a maximum of 25% equity as a conservative hybrid fund.
The Balanced Hybrid is one category that has had no takers so far. That is about to change. Funds in this category can hold “40% to 60% investment in equity & equity related instruments; and 40% to 60% in Debt instruments”,
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This means they would be classified as class I non-equity funds and eligible for 20% LTCG tax with indexation. PPFAS (if they choose to) can change the mandate of their conservative hybrid fund to a balanced hybrid fund. They can include a minimum of 15% arbitrage to ensure the fund’s volatility does not change too much.
Other fund houses cannot freely implement such changes because of a clause in the categorization rules: “Mutual Funds will be permitted to offer either an Aggressive Hybrid fund or Balanced fund.”
In light of the budget 2023 amendments, SEBI should consider removing this clause some that at least one “popular” fund from each AMC’s portfolio can be converted to a balanced hybrid fund.
The money market segment comprising overnight, liquid, and money market funds cannot be tampered with, and until interest rates fall, retail investors will not favour these funds. Tough luck!
Sebi can also consider relaxing rules for other categories to help fund houses adjust their portfolios.
For example, take the case of long-duration funds. These must currently invest in “debt & Money Market Instruments such that the Macaulay duration of the portfolio is greater than seven years”.
Suppose SEBI can modify this to “invest in debt & Money Market Instruments such that the Macaulay duration of the bond portfolio is greater than seven years”. A fund manager can then include the 36% arbitrage to make it a class I non-equity fund.
Admittedly these are naive suggestions and are a long shot. Still, at least the long-term non-equity funds* like international funds (FOF or direct investments), long-duration, gilt, credit risk, corporate bond, banking and PSU, dynamic bond, retirement funds, children’s funds etc., need some tax advantage to compensate investors for the risk they are taking.
* From the point of view of taxation, there are only equity and non-equity funds.
It pains me to write this, as I have always advocated style purity in debt funds. But there is no point in being style pure when no one wants to invest in a fund. The debt fund industry still suffers from the Franklin crisis, and this rule change seems like the last nail in the coffin.
I agree that the above is a far-fetched suggestion, but some help is necessary to enable investor participation in debt funds. Will SEBI oblige?
If they don’t and the finance ministry rejects the representation from AMFI, then arbitrage funds and equity savings funds will become popular. 🙁
Even with the new rule change, a long-term debt fund investment has some tax advantage over an FD or an RD. Bank deposits are taxable each year, often with a mandatory TDS. Mutual funds are only taxable on redemption. So over a period of time, this results in better post-tax returns due to the time value of money. However, it is not adequate compensation for the risk a debt fund investor takes, and some help from the regulator would be much appreciated. Interesting days ahead.
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