2 mutual fund schemes which offer tax efficiency plus debt-MF like returns

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Debt mutual funds have been an instrument of choice while giving exposure to fixed income assets in investment portfolios. Tax efficiency was one of the major reasons for this.

However, from April 1, 2023, there has been a change in income tax laws for mutual fund units bought on or after this date. Capital gains from units of any Mutual Fund (MF) scheme that has invested after this date and has only up to 35% assets in Indian equity would now come under Short-term Capital Gains (STCG) tax regime, irrespective of the duration of the investment. STCG tax is payable at one’s applicable income tax slab rates.

Capital gains from units of those mutual fund schemes that have invested 35%-65% in Indian equity in the MF scheme would qualify for long-term capital gains (LTCG) after 36 months of holding period. LTCG tax of 20% would be applicable, after indexation, for this category.

This means that capital gains from units of pure debt funds would come under Short-term capital gains regime irrespective of the holding period and tax payable will be as per one’s income tax slab rates. This is a major disadvantage. However, there are two mutual fund categories that offer returns similar to debt mutual funds in a tax efficient manner.
These mutual fund categories are – Arbitrage funds and Hybrid funds. However, an investor must consider two scenarios before investing in these mutual fund categories. The first one is where they require money for near-term goals and expenses. They need the investment to be stable and liquid. Investment returns are not a major consideration here. One of the best candidates for near term goals would be an Arbitrage fund which has risk similar to a debt fund but has equity taxation, as the bulk of the underlying asset is equity and equity options. If the investment holding period is less than 12 months the tax rate is 15% and is 10% if held for more than 12 months. Further, there is an exemption of Rs 1 lakh available if Arbitrage fund units are sold after 12 months. Arbitrage funds can offer between 4.5%-6% pa in the one-to-three-year duration, which will depend on the interest rate cycle itself and availability of arbitrage opportunities.Apart from arbitrage funds, an investor can also consider Equity Savings category. This mutual fund category offers returns similar to debt mutual funds but is categorised as an equity fund as per SEBI regulations. Depending on the risk appetite, within this category, one could choose specific funds that self-limit their equity exposure to just 20%, with the rest of the equity portion being invested in Arbitrage instruments. Balance 30% plus will be in debt assets in this kind of fund. Due to it being characterised as an Equity fund, the tax will be 15% on short term capital gains for investment holding period of less than 12 months and 10% on long term capital gains for holding period over 12 months along with benefit of Rs 1 lakh exemption. Equity savings fund funds have the potential to offer between 7-10% pa returns over time; a lot depends on the performance of the different components. The second scenario is where we invest in debt as an asset class as a part of strategic allocation in the investment portfolio. Here we can give allocation to the debt portion of assets through hybrid funds and in the process enjoy better taxation. The sweet spot to operate is the hybrid fund between 35-65% in equity, which will ensure that the taxation after 36 months holding period will be 20% after indexation. Here the effective taxation will mostly be in single digits.

There are three types of hybrid funds – conservative, moderate and aggressive. Depending on their equity investment range, one can invest in the hybrid fund accordingly to match their risk appetite. However, do remember that hybrid funds that invest in equity are that much riskier as compared to pure debt mutual funds.

For instance, a balanced hybrid fund will have approximately 50% in debt papers (actually between 40-60%) and the balance in equity. But as seen earlier this would have LTCG tax treatment of 20% tax after indexation, after 36 months of holding period, with effective tax likely in single digits.

The other option is an aggressive hybrid fund that would have at least 65% Indian equity holding. This will be treated as an equity fund and the taxation will be benign, as explained earlier. The debt portion would be less than 35% in such a fund.

However, the investor must remember that in all hybrid funds the stability of debt comes bound with the volatility and higher risk of equity which forms the balance portion. So, greater tax efficiency does come with increased risk in the case of hybrid funds.

In all categories of hybrid funds, the debt allocation will vary from time to time, as it is a hybrid fund and the fund manager has the flexibility to adjust the asset level in the scheme. So, instead of just pure equity and pure debt funds in our portfolio (to have exposure to these two asset classes), we will now have an appropriate amount of such hybrid funds as required to have the optimal debt allocation along with tax efficiency.

Ideally, it would be a lot easier if we directly invested in pure equity & debt products but we are suggesting a work around for better tax efficiency.

Advantages that debt funds still enjoy over other fixed income options –
The direct debt MF schemes may not be very efficient from a tax standpoint. However, debt asset class is needed for diversification and asset allocation and will continue to find a place in investment portfolios. The debt funds still enjoy various advantages listed as follows:

a) Any capital loss incurred on units of a debt MF can be set off against capital gains and can also be carried forward for up to eight years. This is not possible with FDs, small savings instruments etc. However, it needs to be mentioned that there is little chance of incurring a capital loss on FDs and small savings instruments.

b) Also, the capital gains in units of debt MFs are taxed only on Exit or sale. In case of non-tradeable NCDs, Bonds and FDs which are regular income bearing instruments one needs to pay the tax as and when interest accrues/is paid.

c) In case of a debt MF unit there is no need to compulsorily receive the coupon/ interest as in a periodic interest payment Bond or NCD, if one does not require the money. In the case of a debt MF unit there is flexibility to take out the money invested when one may need it.

d) In normal circumstances, Liquidity is assured by the Asset Management Company in case of debt MFs and one can get the money the next day. That kind of liquidity is provided only by Bank FDs albeit there may be a penalty on premature encashment. For most other fixed income instruments, liquidity is not very good as investment may be subject to lock-in periods and/or pre-mature encashment may require selling the investment (NCDs, Bonds) in the secondary market.

e) There are a good number of underlying papers/ investments in Debt MFs and hence there is risk diversification. As opposed to that FDs/ Bonds are single entity exposure, which results in concentration risk. However, it needs to be mentioned here that in case of bank FDs, the money is insured up to Rs 5 lakh per investor per bank which is not the case for debt MFs. Even so, this insurance exists only for bank FDs and not for other types of fixed income instruments.

f) Professional managers ensure better management of the debt portfolio and manage any risks along the way. Also, institutions like MFs have access to papers at better terms that normal investors may not be able to access.

(Suresh Sadagopan is the MD & Principal Officer at Ladder7 Wealth Planners.)



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