Rise in long-term capital gains tax is a big blow for non-equity mutual funds

Debt mutual funds, which were giving a tough competition to bank fixed deposits, have lost their tax advantage. In a big blow to the mutual fund industry, which was already facing the problem of massive slowdown in inflows into equity funds, the finance minister announced an increase in long-term capital gains tax on non-equity mutual funds from 10% to 20%.

Apart from this, 'long-term' has been redefined as 36 months for non-equity mutual funds. Earlier, it was 12 months. At present, non-equity funds are taxed at 10% before indexation and 20% after indexation, if sold after one year. Indexation is adjusting the purchase price of an asset by the inflation rate.

This reduces capital gains and, hence, the tax burden.

Since all funds that invest less than 65% money in equities are treated as non-equity funds for taxation, the change will also impact gold funds, international funds, fund of funds, etc. These funds together account for 75% of the industry assets under management of around Rs 9 lakh crore.

The category that is likely to be impacted the most is fixed maturity plans (FMPs). FMPs account for 15% of the industry's assets. FMPs with tenure of more than 365 days help investors benefit from double indexation. Such FMPs are bought in one financial year and mature in the third financial year. The purchase price is, therefore, adjusted for inflation twice (one in each financial year). This significantly reduces the capital gains.

That is why FMPs were providing tax-free returns of 8-9% annually and, hence, giving a tough competition to bank fixed deposits.
"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 the tax rate from 10% to 20% could reduce the attractiveness of fixed income schemes such as FMPs significantly," says G Pradeepkumar, CEO, Union KBC Asset Management Company.

Now, if you sell your debt fund units before 36 months, the gains will be added to the income and taxed as per your tax slab. This means that for corporates, the tax rate will be 30% plus surcharge and cess. If you sell after 36 months, you will have to pay tax at the rate of 20% after indexation.

The move will not impact funds where money is parked for a few days or a few months, that is, liquid funds and ultra short term funds, which together account for 37% of the mutual fund industry's assets under management. This is because corporates anyway used to park money in these funds for a few days or months.

"A lot of money from high net worth individuals will find its way from mutual funds to bank deposits as the proposed amendment will take the sheen off debt-oriented mutual funds. However, liquid funds or other short term funds may still remain an attractive option as bank deposit rates for the short term tend to be meager," says Amit Maheshwari, Partner, Ashok Maheshwary & Associates.