The Union Budget 2014 has dealt a big blow to the mutual fund industry: It increased long-term capital gains tax on debt funds to 20 percent (from 10 percent), and changed the definition of long-term for debt funds to 36 months (from 12 months). This makes debt funds less attractive; this also brings them at par with gold and real estate investments, where long-term capital gains tax is charged after 36 months.
The industry is in a state of shock. Most debt fund managers are saying they need to understand the implications of this step, which will take some time. Considering the fact that debt funds (or any fund other than equity) account for 78 percent of total assets (Rs 9.74 lakh crore) managed by mutual funds, the industry is now seriously worried.
The finance minister has made it clear that the step to charge higher tax on debt fund was taken to stop the arbitrage between mutual fund investing and directly buying these instruments from the market. These investors—only 10 percent of investors in debt funds are retail investors and the rest are institutions, such as banks, corporates or sometimes HNIs—were buying debt funds through dividend plans, and thus paying lesser tax as compared to what they would be paying by buying these debt instruments directly.
However, with the introduction of high long-term tax, the entire proposal does not seem attractive at all. “These are smart investors. As it is they stay with a fund for more than a year only to get the tax advantage. There is no way these investors will stay with a fund for three years,” says Vikaas Sachdeva, CEO, Edelweiss Mutual Fund.
Over the last few years, mutual funds have built their corpuses, or AUMs, only on the basis of debt, with their products catering largely to institutional investors. Most equity fund managers are actually happy with the government announcement as it ends the way the industry has functioned so far. Now, the industry will have to concentrate on retail investors who invest in equity funds and will have to cater to him for the longer term. “I believe the finance minister is trying to prepare the investor for a long-term and more objective approach towards mutual funds, which is more investments and less tax arbitrage,” says Sandesh Kirkire, CEO of Kotak Mutual Fund.
The finance minister has hiked the investment limit from Rs 1 lakh to Rs 1.5 lakh under Section 80c, which is a step in the right direction as it will boost investments in the ELSS category, in products like fixed deposits and PPFs. This again could become a worrying problem for mutual funds as investors will move their funds from MFS to ELSS products.
The uniform KYC for investing in all financial instruments, and a single operating demat account are steps appreciated by the industry as they will reduce a lot of paperwork.
The government has also increased its composite cap of FDI in the insurance sector to 49 percent; this is considered to be a step towards more globalisation and reforms. “This measure should provide impetus for spurring growth of the insurance industry and enable foreign players to bring in capital required for growing distribution, product suite and strengthening the risk framework. This move may enable existing players to expand their reach in tier-II and tier-III cities,” says Shashwat Sharma, Partner, KPMG India.
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