Sunday, June 23, 2024

Heavier tax on debt funds will hit our corporate bond market hard

The withdrawal of India’s capital gains tax benefit on debt mutual funds is significant for various reasons. The first is that it seems aimed at the country’s overall goal of a tax structure that is simple, with few exemptions and benefits. Second, following from the first, it indicates that over the next few years, just as all debt is taxed in a similar manner, equity sops may also end. Already dividends are taxed at the slab rate and no capital gains are tax-free. The 1 lakh limit may also go at some point. Third, while the market absorbs these announcements, it should be prepared for further such changes that withdraw tax benefits. Alternative structures are presently being offered for income tax and corporate tax. One may expect convergence in the next few years.

Is this a good move? For the government, it is evidently good as tax revenue increases, which is what it needs, given that today’s structure offers limited buoyancy. The economy is stuck in a 6-8% growth band and a 10% rate that can generate more revenue looks like a long journey. Therefore it is a winning situation, as returns on savings held in debt will draw slab-rate revenue.

For mutual funds, this is a setback because debt funds account for around a third of total assets under management (AUM). So the withdrawal of a tax benefit that is probably their main allure will mean a shift of funds away to either equity/hybrid schemes or fixed deposits and directly bought bonds. Even within debt funds, schemes loaded with, say, government securities had been giving lower returns of 6-7% but looked better with the tax benefit. In fact, an anomaly was that if one purchased corporate bonds giving an 8% return, the interest earned was taxed at the slab rate. However, in the hands of a mutual fund, after adjusting for fund expenses, one could pay just 20% tax on an indexed value if held for at least three years.

For individuals, this is a big blow. The only balm applied is that it would hold for investments made post 1 April 2023, unlike the last time when the ‘long term’ definition was changed from 1 to 3 years where it was imposed retrospectively. Logically, if the government earns higher tax revenue, it has to be paid by unit holders, whether corporates or retail investors. As the economy has been hit with relentless inflation of 6% plus for three successive years, the capital gains sop helped to partly protect returns. Form now onwards, this benefit disappears.

Banks and NBFCs would be better off now. In fact, they had been arguing for the same capital gains benefit on deposits kept for 3 years and above as was the case with debt mutual funds. Now a level playing field has been provided, as that benefit has been altogether abolished. More funds are likely to flow into deposits now; and after assessing the situation, banks could also lower their rates as there are no risk-free alternatives for savers.

That said, the biggest blow is for India’s corporate bond market. There have been several attempts made to grow this market by the government, Sebi and RBI. Now two things will push the market back significantly. First, the ability of mutual funds to invest is limited by final investors opting for such schemes. If they migrate away from them, then demand for corporate debt will come down.

Second, at the retail level, this move is quite detrimental. Individuals as a rule should not get directly into the debt market because it is hard to understand the dynamics of bonds. Unlike equity, where a company’s share is easy to identify and hence buy and sell, bonds pose challenges. Bonds have a coupon rate and a tenure, and as time elapses, their implicit yield is hard to grasp. Besides, there is not much trading that takes place for most, which means they cannot be bought and sold easily.

Presently, investors buy units of a mutual fund scheme which in turn invests the money. Now with their net returns coming down sharply, it does not make sense to invest in debt funds. While RBI has been trying to get retail investors to invest directly in government securities, it made more sense for people to invest through a mutual fund window, not just for returns but also access to liquidity. Now, one has to think hard before entering this market, as it is not easy to sell securities that do not trade on a daily basis.

The setback to India’s market for corporate bonds is probably the most significant impact of this latest move. Companies with a lower rating of, say ‘A’, which could hope to attract mutual fund money, will now find it harder to find investors. At the retail level, there is risk aversion for lower-rated bonds. The ability of mutual funds to invest in debt depends on how savers deploy their funds. While corporates would still consider such deployment, retail investment, which accounts for 55-60% of the sector’s total AUM, would surely draw back from the debt segment.

Given the way in which Indian tax laws have evolved over the past 10 years, one could see the change announced on 24 March coming. Equity market gains would also be taxed at the slab rate once the logic of a level playing field comes to determine tax policy. The rationale offered would be that providing equity-gain sops has not moved the needle of private investment.

Madan Sabnavis is chief economist, Bank of Baroda, and author of ‘Banking Trends and Controversies’

Catch all the Business News, Market News, Breaking News Events and Latest News Updates on Live Mint.
Download The Mint News App to get Daily Market Updates.

More
Less

#Heavier #tax #debt #funds #hit #corporate #bond #market #hard

Related Articles

LEAVE A REPLY

Please enter your comment!
Please enter your name here

Latest Articles