Gains from non-equity mutual funds are eligible for taxation as long-term capital gains (LTCG) where the units are held by the investors for more than three years. The amended Finance Bill, 2023, as passed by Parliament, has sought to curtail LTCG benefits by deeming the gains arising from ‘specified mutual funds’ as short-term capital gains (STCGs). This is irrespective of the period for which the units are held by investors. ‘Specified mutual funds’ here refer to mutual funds where not more than 35 percent of their total proceeds are invested in equity shares of domestic companies. This new tax treatment will apply, prospectively, to mutual fund units acquired on or after April 1, 2023.
Pursuant to the above change, benefits in the form of lower tax rates and indexation available to LTCG on the sale of such non-equity mutual funds will be replaced by taxation at the maximum marginal rate, as applicable to STCG. An important point to note here would be that the gains would still be characterised as capital gains, which will, at least, allow investors to set off any other short-term capital losses that are incurred by them. Further, this change, though seemingly applicable only to debt mutual funds, will impact several other types of non-equity funds, including gold/silver funds, outbound mutual funds and even, equity fund of funds.
Forcing Portfolio Changes
The Finance Bill, 2023, as originally presented on February 1, 2023, introduced a similar tax treatment for market-linked debentures (MLDs). Extending the same to non-equity mutual funds, while moving amendments to the Bill, appears to be, therefore, an afterthought. If one applies the rationale for introducing such tax treatment for MLDs (the instruments are more like derivatives to non-equity mutual funds), the logic fails. Non-equity mutual funds are securities (different from derivatives) and have all the inherent risks associated with such investments. If, at all, investors should have been encouraged to invest in such securities for a longer tenure.
While there are several attributes to consider in evaluating investment opportunities, LTCG taxation has been an important attribute, especially for investment in such non-equity mutual funds. With the proposed change, retail investors may stay away from non-equity mutual funds because if they are risk-averse and conservative in their approach, they may just find it easier to park monies in fixed deposits. Another reason could be if they are happy to take some risk, they may prefer to invest in equity funds.
One area where retail investors could do with professional help would be debt investments which, after the proposed amendment, they may not tap into. Similarly, retail investors will be encouraged to buy and hold bullion directly rather than invest through an exchange-traded fund (ETF) scheme, which is contrary to the government’s agenda of financialisation of savings. Similarly, retail investors may think twice before diversifying their portfolios by investing in offshore securities through mutual funds, again an area where retail investors could do with professional help. Thus, after the amendment, investors’ portfolios may not be as well balanced and diversified, although the exchequer may gain some extra tax revenue.
Bond Markets May Hurt
Indian corporate bonds markets are, generally, considered to be in the development stage with mutual funds playing one of the leading roles to channelise retail funds in this market. Deepening of the Indian bond markets has been on the agenda of the government for some time now and this change in tax treatment could run counter to that agenda.
Further, Indian borrowers may find it more challenging to raise longer tenure debt as one of the key sources of such capital may no longer be around and they may have to fall back on banks and NBFCs. In an environment where the risks of asset-liability mismatches are under the spotlight, a change in the supply side of the bond market will only exacerbate Asset and Liability Management (ALM) risks and increase borrowing costs in an already inflationary environment. This along with the increase in taxation of coupons on bonds payable to foreign investors will ensure tumultuous bonds markets in the short term.
Strange as it may sound, mutual funds which are investing more than 35 percent in domestic equities, albeit indirectly, may find themselves to be within the scope of these new provisions as these provisions do not contemplate indirect investments through fund of funds (FOF) structures. Hopefully, this is only an oversight and not intended. Since the provisions become effective from 1 April 2023, it may really help if the authorities intervene at the earliest.
While appreciating that taxation policies are the prerogative of the government, it is imperative to find the right set of balance that encourages long-tenure savings and leads to the growth of markets and the economy, in general. The amendment with respect to the taxation of non-equity mutual funds is a significant change which will have a ripple effect across the mutual fund industry, investor behaviour, bond markets, bullion markets, etc. The government may want to consider the potential impact of the change in totality, and defer it until all relevant aspects are considered.
Nehal Sampat is partner, Price Waterhouse & Co LLP. Views are personal, and do not represent the stand of this publication.