The Indian parliament has lashed out at the country’s burgeoning debt market. As part of the budget, he proposed an amendment to the Finance Act that would deprive debt mutual funds of the tax breaks they currently enjoy.
A debt investment fund is an investment fund with an equity allocation of no more than 35%. For shareholders who have invested in such funds for at least three years, returns will not be treated as long-term capital gains subject to a lower-than-investor marginal tax rate.
This means that debt mutual funds are now tax-equivalent to bank term deposits. Until now, banks preferred fixed deposits if they were untouched for at least three years, as long-term capital gains were taxed at 20% with indexation or 10% without indexation.
Indexing is the recalibration of the original investment value to account for inflation since the time of investment. This reduced the capital gains on which tax is payable.
The Income Tax Department provides an indexation table in which 2001-2002, the price level is 100. Suppose that in 2017-2018 you invested Rs 100,000 in a mutual debt fund and redeemed it in 2022-23. The index for 2017-18 is 272, and the index for 2022-23 is 331. So the inflation-adjusted value of Rs 100,000 for 2022-23 is Rs. 331/272 x 100,000 or 121,69121 rupees. Capital gains are calculated as if the initial investment was Rs 121,691.
This relief has been removed for debt mutual funds invested after April 1.
This primarily affects companies that are the biggest users of this asset class, using it to reduce their tax costs. Companies must store cash left over after dividends, taxes and other expenses. With some cash, they can move quickly when they see an investment opportunity, keeping a large amount on their books rather than immediately returning it to shareholders.
Debt mutual funds have proven to be useful assets for storing such corporate surpluses because they are sufficiently liquid, offer decent returns, and so far offer tax benefits if held for at least three years.
But the government decided it could not afford to give such tax breaks to wealthy companies and withdrew the tax haven. Businesses lose, and banks lose a bit.
Fixed deposits have lost their lustre in the eyes of middle-class savers since the low-interest regime ended just over a year ago. This has led to such low rates of return that savers have started to look for new ways to invest, such as mutual funds and equity-linked savings schemes.
Banks also did not lend much and did not face a problem due to the reduced flow of deposits. But if banks want to start lending again, they need deposits. Tax-favoured debt mutual funds have been an attractive alternative to bank deposits. You can’t blame the banks for hoping to end this deposit-killing mutual debt fund tax break.
Now the government has granted the banks’ wish and increased the tax. Of course, companies with large reserves will see their tax bill rise. The move will also affect the corporate debt market, and even successful debt packages like Bharat Bonds will find fewer borrowers.
A vibrant bond market is essential to finance projects with a long gestation period. Banks are ideal for short-term lending: their liabilities, mainly deposits, have short maturities and should ideally be invested in assets of similar maturities. On the other hand, bonds can have longer maturities and provide the option of financing on extended terms.
When bonds finance a project, the costs are scrutinized by several analysts, brokers and busy organizations like the Hindenburg. When it comes to a bank loan, some bankers decide on the project’s viability, reasonable costs, etc.
The bond market can certainly grow without tax relief, but it will take a long time. And bond markets thrive when the risks associated with investing in bonds — exchange and interest rates — are freely hedged using derivatives. However, in the recent budget, the government sharply increased the securities transaction tax (STT) on futures and options, further hampering hedging and growth in the bond market.