Finance Bill 2023. Investors rush to debt MFs before tax advantage vanishes

With just a day to go before the long-term capital gain tax becomes history, mutual fund houses are hard-selling passive Target Maturity Funds, which provide a targeted return over a period of time.

While scrapping the long-term capital gain tax benefit for debt funds through the Finance Bill amendment last week, the government has allowed investments made up to March 31 to be grandfathered for the next three years to avail long-term capital gain tax.

At present, investors in debt funds pay income tax on capital gains according to the tax slab for a holding period of three years. After three years, these funds pay tax of either 20 per cent with indexation benefits, or 10 per cent without indexation benefit.

Come April 1, capital gains arising from debt-oriented mutual fund schemes will be treated as short-term capital gain, irrespective of the holding period. Investors in such schemes will have to pay tax in line with their income slab.

Most of the mutual fund distributors are convincing investors to break some money from bank fixed deposit and invest in Target Maturity Funds before March 31 to take advantage of the tax benefit.

Radhika Gupta, MD & CEO, Edelweiss Mutual Fund, said: “We see a good inflow of investments into TMF as the fiscal year comes to an end.”

Pankaj Pathak, Fund Manger, Quantum AMC, said there is an opportunity for investors to enjoy the long-term capital gain benefit if they invest before March-end.

“However, tax arbitrage is not the only thing that debt funds offer. Now, with similar tax treat as fixed deposits, investors will look at other more important aspects of debt funds like diversified portfolio, market linked performance and liquidity,” he said.

Rise in interest rate

The debt fund asset under management has been falling steadily in the last few month with a steady rise in interest rate. It has dipped 13 per cent last month to ₹12.30-lakh crore against ₹14.09-lakh crore logged in February 2022, according to the Association of Mutual Funds in India data.

Even with the tax advantage, debt funds witnessed a net outflow of ₹2.3-lakh crore last year amid consistent rising interest rate cycle. This was much higher than an outflow of ₹34,545 crore.

The proposed changes targets mainly high networth investors and family offices who gained from the tax arbitrage under the existing tax regime. The tax policy of the country is slowly moving to a simple, consistent tax regime, with no room for tax exemptions and arbitrage, said Sanjay Rathore, an independent MF distributor.

A Balasubramanian, Managing Director, Aditya Birla Sun Life Asset Management Company, said the high networth investors and corporates will prefer debt mutual funds as part of their cash management despite the removal of long-term capital gain tax because breaking a fixed deposit attracts hefty penalty besides, they also get the advantage of mark-to-market gain.

Besides Target Maturity Fund, there has been good inflow into actively managed debt funds due to the last- minute tax planning before the LTCG goes next year, he added.

Mahendra Jajoo, CIO, Fixed Income, Mirae Asset Investment Managers, said there was a fair amount of traction towards Target Maturity Funds, but the flows would have been substantial if the investment opportunity provided was more than one-week.

Though indexation was just one of the favorable factors of debt funds, the potential capital gain when rates fall together with liquidity across a range of duration and credit pockets is quite a powerful feature. There may be a bit of immediate disappointment, the flows should resume as interest environment turns more constructive, he added.

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