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Tax Changes to Debt funds from the budget

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Debt funds get a blow from the budget  

The increase in long term capital gains tax from 10% to 20% is likely to make debt funds less attractive.

The increase in long term capital gains tax for debt funds from 10% to 20% and the change in withholding period for long term from 12 months to 36 months has ended the arbitrage which existed between debt funds and other debt instruments, particularly bank deposits.  

Fund officials said that the move is likely to make one year FMPs less attractive. "The budget has changed the definition of long term for debt funds from 12 months to 36 months. This removes the anomaly of tax between bank deposits and debt funds. One year FMPs will be hit the most. The increase in tax will make bank deposits more attractive," said D P Singh, CMO, Chief Marketing Officer (Domestic Business), SBI Mutual Fund.

"The move to increase the holding period for long term capital gains tax for fixed income funds from 12 months to 36 months combined with the increase in tax rate from 10% to 20% could reduce the attractiveness of the fixed income schemes such as FMPs very significantly," said G Pradeepkumar, CEO, Union KBC Mutual Fund.

Some say that fund managers can now take undue risks to generate higher returns. "The arbitrage had to end one day. One pitfall is that fund managers may investment in low investment grade instruments to generate higher returns which can pose a risk for investors. This will clearly benefit banks," said the sales head of a foreign fund house.

Hemant Rustagi of Wiseinvest Advisors is of the view that certain debt funds like hybrid funds and MIPs can still give investors better returns as compared to other debt instruments. "If markets do well in the next two years MIPs and hybrid funds which invest some portion in equity can give you attractive returns. Tax incentives are needed to increase the reach of mutual funds. However, with the new tax regime, the arbitrage has ended," said Hemant.

Fund officials say that there is a possibility of investors redeeming from debt funds. "In the near to medium term, it could potentially result in outflows from some segments of investors who have an investment horizon under three years and who are also in the high tax bracket. To the extent that mutual funds benefited from concessional rate of taxation vis-à-vis other instruments, the competitive edge goes down. But at the same time, active management of funds and ability to generate additional return by playing an asset-liability duration mismatch, benefits of liquidity and ability to bring in some credit spreads cannot be taken away. As it stands now, MFs will have to compete with other fixed income alternative purely on merits of investment management capability instead of a direct tax concession. Another way to look at this is that a lot of long term money which went into fixed income mutual funds only because of tax concessions will now be more willing to explore equity investments. In cases where the time horizon is not long enough for equity, I expect some of the short term money in the one to three year bucket to move into arbitrage funds

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