Govt proposes changes in Debt mutual funds – how does this impact banks, life insurers, NBFCs and others

The central government has introduced amendments to taxation on debt mutual funds with debt MFs now being taxed at a marginal tax rate across tenures than the earlier benefit of long-term capital gains with indexation for debt investments for over 3 years.

The Finance Bill, which gives effect to taxation proposals for 2023-24, was passed by Lok Sabha on Friday. The government had moved 64 official amendments to the bill.

Among other proposals, the bill has proposed that from April 1, investments in debt mutual funds will be taxed as short-term capital gains. The move would strip investors of the long-term tax benefits that had made such investments popular.

Global brokerage firm CLSA assessed the impact of the changes proposed in the Finance Bill on mutual funds, banks, life insurance firms NBFCs and HFCs:

Budget amendment- Taxation change on debt Mutual funds

• The budget amendment proposes to tax debt mutual funds at short-term capital gains (STCG) rate which is the marginal tax rate irrespective of tenure.
• Earlier, investments in debt mutual funds for over 3 years were subject to a long-term capital gain (LTCG) tax rate of 20 per cent post-indexation.
• With this change and the changes proposed in the budget on life savings products, there is no tax arbitrage left across debt instruments be its bank deposits, debt MFs, or life insurance savings products.

Impact on Mutual funds – Moderately negative

• This is a negative for the MF industry having non-liquid debt AUMs of Rs 8 trillion (19% of AUMs) – as the relative attractiveness due to tax arbitrage goes away.
• Liquid MFs of Rs 6.6 trillion will not be impacted materially as they are anyways a short-term product and there is no material change in tax attractiveness.
• For AMCs, revenue contribution from non-liquid debt products is 11-14 per cent. The brokerage believes this is moderate to low impact as the bulk of the revenue/profitability for AMCs accrues from equity AUMs and non-liquid debt AUMs are neither higher growth nor higher profitability segments.

Impact on Life insurers – Positive at the margin:

• There is no amendment to the tax changes proposed in the budget and hence the status quo remains with returns on incremental premiums below Rs 5 lakh will be taxed at the individual tax rate.
• While this will impact non-PAR savings sales against pre-budget levels, the change in taxation for debt MFs now bridges the tax arbitrage and brings all debt products at par.
• So, Life insurers from being a superior product pre-budget (no tax on debt savings) moved to be an inferior product post-budget and now it is neutral as alternate debt investments are also taxed at the marginal tax rate.
• At these valuations, CLSA believes this is a marginal positive for Life insurers.

Impact on banks – small positive:

• Post the budget changes in insurance and amendment changes proposed for debt MFs, tax arbitrage against bank deposits is gone.
• Earlier, interest on bank deposits was taxed at the individual tax rate and debt MFs enjoyed LTCG of 20 per cent with indexation, and life savings products enjoyed tax-free returns.
• At the margin front, this is positive for banks but the quantum cannot be very high as bank deposits’ market size is Rs180trn vs total debt MF size of Rs 8 trillion.

Impact on NBFCs:

The non-banking finance companies (NBFCs) and housing finance companies (HFCs) would have some reliance on their funding from mutual funds. They may have to rely more on bank for funding than mutual funds with potentially lower inflows in debt MFs.