(At the outset, apologies for all the acronyms in this article but they’re so much simpler to keep typing than their long-winded full forms.) 

What happened?

The recent Budget 2014 in the space of a few words wrought much havoc in the arena of investing in debt schemes of mutual funds. As is usual in such circumstances, the stages the drama went through were: announcement, no reaction, delayed reaction, ThisIsOutrageous reaction, mild confusion, complete confusion, partial clarificatory pointless rollback, WeCanLiveWithThis reaction, jugaad workaround from the industry and we’re currently at procedural confusion and resigned acceptance.

In short, the Finance Bill has changed the definition of “long term” in respect of mutual fund debt investments (MFDI) from 1 year to 3 years. This means that if you want any gains earned from redemption (including maturity) of MFDI to be treated as long-term capital gains (LTCG) for calculating tax payable, you need to have stayed invested in that MFDI for at least 3 years (hitherto, 1 year).

It’s beneficial to have such gains treated as LTCG because that allows you to claim indexation, which in turn reduces the taxable gain (in some cases all the way down past zero into a non-taxable loss) and therefore reduces the amount of tax you have to pay. Which is always nice. Indexation itself is worthy of a whole other article, but the above suffices for now.

There are at least a couple of things hare-brained about this move to increase the long term holding definition from 1 to 3 years. One is that, all protestations to the contrary, this does amount to retrospective taxation, which is just what the FM promised a few paragraphs earlier to eschew forever. It’s retrospective because it applies to all current investments, including those you made 11 months or 1 month ago in the belief that next month or 11 months hence these would result in long term capital gains. Well, now they won’t unless you continue to hold them till the total holding period exceeds 3 years. The second reason it’s hare-brained is because it penalises all the small investors (that’s you and me) on the pretext of curbing misuse by the big investors (which is what the FM claims he’s trying to do as he said in his Budget Speech).

But it’s done and dusted now so we have to live with it.

What does that mean?

Let’s see what it means in practical terms.

And do bear in mind that MFDI is basically all mutual fund schemes that aren’t explicitly equity, i.e., that have less than 65% of their investments in equity. That includes gold funds, balanced funds, feeder funds, MIPs and so on.

Firstly, for all MFDI under 3 years, there is no longer any tax advantage over a bank or any other FD — all are taxed at the same rate, which is your individual tax rate. There is still a marginal cash flow advantage, because an FD will have tax deducted at source (TDS) before you get the interest in hand, whereas for an MFDI, you’ll have to pay the tax either as advance tax or when you file your return. So, you’ll have a short-lived extra cash flow in hand via an MFDI. And if you’re not in the tax bracket, then the MFDI route saves you from the hassle of filing a form 15G or claiming a refund.

From a safety perspective, an MFDI is as safe as always, which is to say a bit more than a corporate FD and about the same as a bank FD.

From a liquidity perspective, after the exit load period is over (varies from scheme to scheme), MFDI’s are a lot easier to liquidate than a corporate FD and about as simple as a bank FD.

From a return perspective, the bank and corporate FD rates are known in advance when you make the deposit and stay fixed till the deposit matures. For MFDI, it’s not so simple. You could ascertain an indicative yield but that’s not guaranteed. Which is both good and bad: good because in a good bond market you could end up earning quite a bit more than an FD, but bad, because you could do just the opposite.

From a fund manager’s perspective this 3 year horizon is probably good as it ensure funds stay in the scheme for that period at least which enables longer term investing decisions. From a financial advisor’s perspective it’s great because there are a lot less maturity dates to track.

Is this the beginning of the end or the end of the…?

So, should there still be place for MFDI in your portfolio?

Definitely.

One, for an investment horizon greater than 3 years and with an ability to take a bit of a risk, MFDI will probably deliver better returns than an FD.

Two, for very short-term liquidity, i.e., funds that you need to park for short periods either to redeem or to switch to equity systematically, a liquid fund with the daily dividend option is still great. True, the revised (and correct) calculation of dividend distribution tax (DDT, seriously) will reduce yields a bit, but it’s still every bit as tax-effective and liquid as ever.

Three, even for under 3 years’ horizons, once the exit load period is over, your MFDI is as liquid as ever and at least gives you the option to exit even if the STCG (hint: STCG is like LTCG but “short”) sword strikes and the potential to earn better returns than from an FD is good. And if you don’t exit, then One above applies.

Three, the good ol’ Indian jugaad machine is live and well. Those FMPs (fixed maturity plans) that you invested in less than a year ago and which on maturity would now be short-term holdings? Guess what? The funds have started extending those schemes so that they now run for over 3 years before maturing, so they become LTCG. One catch is that you will have to stay invested for that extended period, so liquidity goes out the window. If that doesn’t matter to you, that’s a good option. And it’s your option, it’s not automatic. Close to the original maturity date, the fund house sends you a form for you to fill in to opt for the extension. You can opt to extend your entire investment or only a part of it, and you need to lodge the form before the original date of maturity. If you don’t, your original investment matures, it gets paid to you together with gains and you pay short-term capital gains tax.

In short, debt in the time of MoJa is transformed but still kicking.