The Importance Of Tax Fairness For MF Investors 

Proper allocation of the portfolio to equity, debt, gold is important.

Taxation on investment profits or gains is like the proverbial two sides of a coin: The investor would think it is over-taxed and the authorities tend to believe it is under-taxed. Having said that, pre-budget is the time to vent out the wish list.

In mutual fund (MF) investments, there is a tax-break only in one category of funds, that is equity linked savings scheme (ELSS), under section 80C of Income Tax Act, with a lock-in of three years. In debt funds, there is no corresponding tax break. While it is good to give an incentive to savings/investments that have a social benefit in the form of tax break, there is a strong case for a similar benefit in debt funds. There is a macro message in this: In a sense the government is telling the population that these investments, which are approved under section 80C, are good for you and in exchange for doing this, you will be getting a tax lollipop. Somewhere the message is getting distorted that while investments in equity funds is good, debt funds are not as good, and is therefore not incentivised in that sense. For every investor, proper allocation of the portfolio to equity, debt, gold is important. Historically, debt as an asset class has given returns less than equity but has been more stable.

The purpose of ELSS being eligible U/S 80C is to encourage long term investments and also help the investee companies. Likewise, in debt, 80C eligibility would encourage investments in an avenue that is stable in returns and hence less risky. The regulators have notified earlier, that large corporates should raise at least 25% of incremental resources through issuance of bonds, to broad-base their resources beyond traditional bank funding. Recently, RBI (Reserve Bank of India) has proposed some changes in the portfolio classification of banks, where corporate bonds are proposed to be made eligible for the hold-to-maturity (HTM) component of banks’ portfolio, which does not have mark-to-market requirements. Another logical step would be to allow debt linked savings schemes (DLSS) in MFs, so that the investee companies get the resources. It’s eligibility for DLSS U/s 80C may be made subject to conditions e.g. lock-in of 3 years or 5 years, credit rating of bonds in portfolio of a certain profile.

The other aspect of fairness to debt mutual fund investors is that the holding period for eligibility for long term capital gains (LTCG) taxation has been increased from one year to three years, in 2014. For listed debt securities, however, the holding period is one year for LTCG. There is a case for bringing down the eligible holding period to one year for debt MFs as well. To look at the other side of the coin, the perspective of the authorities, they may have thought that MF is a vehicle for retail investors who deserve tax efficiency whereas for defensive debt funds like liquid funds, corporates comprise the larger chunk of investments. If that is the rationale, a cap on investments may be imposed for the one-year eligibility for LTCG taxation in debt funds, e.g. ₹10 lakh per financial year per PAN, so that the equality with listed bonds for LTCG is for retail investors only. For equity funds, the required holding period for LTCG is 1 year, whereas equity is more volatile. Again, the “message” from the government in terms of taxation rules, is getting distorted, as a less volatile avenue requires a relatively lesser holding period.

There are certain other aspects of tax anomaly that may be considered in the forthcoming union budget. There are options or plans within the same fund, e.g. dividend option / growth option, regular plan / direct plan. The MF scheme is the same, and the portfolio is same, for these options. However, when the investor switches from one to the other, it is considered as a redemption (sale) and purchase, with consequent tax implications. Investors should be spared the tax incidence while switching within the same fund. Then there are fund of funds (FoF), which invest in units of other fund(s). An FoF is taxed as debt, even if the underlying funds are equity. There is one exception to it, if 95% of the portfolio is invested in domestic equity ETFs, then the FoF is taxed as equity. It is an anomaly that if a FoF is invested 100% in equity funds, taxation is that of debt. Since the taxation structure is getting reviewed for modifications in the budget preparation process, this is an appropriate time to iron out the anomalies.


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