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Market Update

Mar 25, 2023

Impact of Taxation Change of Non-equity MFs
In a surprise move late last night, the government announced a proposal to amend the taxation on non- equity mutual funds. The same was passed into a bill earlier today. As per the current understanding this is a very significant announcement which will have a structural impact on debt mutual funds as an instrument and fixed income as an asset class. In the note, we discuss the changes, its impact, and the way forward.

Amendments to the Finance Bill
Gains from mutual funds which invest less than 35% in Indian equities after April 01, 2023, will be deemed as short-term capital gains and will be taxed at the marginal tax rate of the investor. Earlier, if these funds were held for more than 3 years, they were taxed as long-term capital gain at a tax rate of 20% with an indexation benefit. This shall impact not only debt mutual funds but also gold and silver ETFs/funds, funds- of-funds, and international feeder funds (domiciled in India), etc. The tax change in not retrospective and hence will not impact the existing investments; it will only apply to investments made after April 01, 2023.

One of the key themes across budgets for the current Indian government has been the removal of tax arbitrage and rationalisation of tax. With these amendments, debt instruments like bank deposits, debt mutual funds and life insurance products have a similar tax treatment. We believe that the government may continue to plug any such tax arbitrages in future as well.

Way forward

Accelerating planned deployment- Since the change in taxation is applicable for investments made post March 31, 2023 only, investors should use the opportunity to plan investment allocation to these funds in the next few days to take advantage of the long term capital gain tax and indexation. For investors that were waiting for higher yields, the impact cost of taxation would outweigh additional returns made from timing the entry.
Increased reinvestment cost- The change in tax structure has also increased reinvestment costs, hence for money already invested in debt mutual funds, investors should try to maximize the holding time period.
Matching investment horizon with duration- Investors should look to match the duration of debt mutual funds with their investment horizons and risk appetites. It is important to note that additional duration comes with increased volatility. Given the global bond market volatility and the current changes, Indian bond markets may remain volatile and could lead to mark-to-market impact for high duration funds.
Other opportunities- Such structural changes tend to throw up opportunities for investors from both the near-term and long-term points of view. We believe other instruments like REITs and INVITs, direct holding of corporate bonds, government bonds, corporate fixed deposits, hybrid mutual funds could become attractive.
Tax no longer a consideration- Investors will have to take duration or credit risk into consideration before making an investment decisions. As we have been highlighting, selective high yield structured credit opportunities could lead to yield enhancement in client portfolios.

Over the next few days, we will assess the primary and secondary implications of these changes in greater detail and refresh our long-term fixed income investing framework. We will then share our findings and recommendations with you.

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