Union Budget 2014-15 - impact on mutual funds and fixed income investments

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Union Budget 2014-15 - impact on mutual funds and fixed income investments

  1. 1. RETAIL RESEARCH Prologue: The proposals made in the Union Budget by the Hon Finance Minister, Mr. Arun Jaitley on July 10, 2014 took away some of the tax benefits from the investments in the Debt Mutual Funds. However, Debt Mutual Funds investments are still attractive considering the tax benefits in the longer tenure investments. The following are some of major proposals made in the Union Budget on mutual funds investments. Proposal Existing Proposed takes effect from Impact Hike in investment limit in section 80 C. 80 C investment limit is up to Rs. 1 lakh. 80 C investment limit is hiked from Rs. 1 lakh to Rs. 1.50 lakh. ‐ Investors can get higher tax benefit on amounts invested in ELSS up to 1.5 lakh. Uniform KYC for investing in all financial instruments and single operating demat account. Require multiple KYC for investing in products regulated by different regulators. Uniform KYC for investing in all financial instruments. ‐ Enables investors to do hassle free transactions across all financial instruments through on demat account. Increase in tenure for availing long‐term capital gains benefit on debt‐oriented mutual funds (i.e, other than a unit of equity oriented fund). Long‐term capital gain is applicable if the units in Debt funds are kept for more than a year. Long‐term capital gain is applicable if the units of Debt funds are kept for more than 3 years. 1 April 2015 (in relation to the assessment year 2015‐16 and subsequent assessment years) Impacts the investors who have investment horizon between one to three years. It has reduced the tax arbitrage between Fixed Deposit and Debt mutual funds making FMPs less attractive. Doubt exists about applicability of new provisions to amounts withdrawn after April 01, 2014 Rise in long‐term capital gains tax rate on debt‐oriented mutual funds (i.e, other than a unit of equity oriented fund). the long‐term capital gain is taxed at 20.6% with indexation or 10.3% without indexation whichever is lower Long‐term capital gain is chargeable to tax at the rate of 20.6% with indexation benefit. (10.3% without indexation is removed). 1 April 2015 Now investors will offer long‐term capital gain tax after three years at the rate of 20% with indexation. (10% with indexation is removed). So, debt mutual funds including FMPs with the time horizon or maturity period below three years become unattractive. Change in the methodology of calculating Dividend Distribution Tax (DDT). Dividend Distribution Tax (DDT) is paid on the income distributed net of taxes by the AMC The amount of distributable income received by the unit holder is grossed up while computing DDT. (explained below) 1 October 2014 Investors lose out 6.26% as additional tax outflow. No impact on AMC side. (explained below) Marginal increase in the Government borrowing program. In interim Budget (presented by Mr. P. Chidambaram on Feb 17, 2014), Gross market borrowing for 2014‐15 was kept at 5,97,000 crore rupees, net market borrowing at 4,57,000 crore rupees, 5.9% higher than the level in 2013‐14. As per the proposals presented by Finance Minister Mr. Arun Jaitley, the gross borrowings of the government in 2014‐15 are pegged at Rs 6 lakh crore, 6.4% higher than the level in 2013‐14. ‐ No major impact on yield curve. But any upward revision in borrowing numbers for the fiscal will put pressure on the longer end of the yield curve. RETAIL RESEARCH July 11, 2014 Union Budget 2014‐15 ‐ Impact on Mutual Funds and Fixed Income Investments
  2. 2. RETAIL RESEARCH Explanation: 1. Increase in the long‐term capital gains tax rate 20% with indexation and the tenure from 1 to 3 years (other than a unit of equity oriented fund): So far, the period of holding in debt mutual funds for qualifying it as short‐term capital gain is not more than 12 months while for qualifying as long‐term capital gain is more than 12 months. Now it is proposed that the short‐term capital gain is applicable for debt oriented funds if the units are held for not more than 36 months. Further, the Finance Minister has proposed to do away with the option of paying LTCG of 10.3% (without indexation) meaning that these will now be taxed @ 20.6% with indexation. So far, the long‐term capital gain is taxed at 20.6% with indexation or 10.3% without indexation whichever is lower. This will impact the investments in debt mutual funds for investors those who want to invest in with the time horizon of 1 to 3 years. Anyway, redemptions made in debt mutual funds within one year are considered as short term and taxed as per the investors’ tax bracket. So far, FMPs have been attractive option for double indexation benefit with the maturity of not less than 366 days wherein an investor can get the benefit of indexation by spreading the investment across two or three Financial Years (if he invest in FMP with the maturity of not less than 366 days on 31st march of a year). Now, the FMPs or any funds other than equity oriented funds will lose out the benefit. However, the indexation benefit is available if the investments in FMPs or any funds other than equity oriented funds for at least 3 years. This is applicable from 1st April 2015. Doubt exists about applicability of new provisions to amounts withdrawn after April 01, 2014. Interestingly, investing in debt instruments such as listed NCDs still retain the benefit of long‐term capital gains. That means the NCDs that are sold after a year are long‐term capital assets and the gains are taxed with the rate of 10.3% (the indexation benefit is not available for bonds and debentures). A sum of more than 1.6 lakh crores has been invested in FMPs by various categories of investors. If this proposal is implemented, most of these monies will not get renewed and the month of Feb and Mar 2015 could see turbulence in the interbank market to cope with this redemption (though it could be temporary). 2. Change in the methodology of calculating Dividend Distribution Tax (DDT): Any dividends which are declared from mutual funds are exempted from tax in the hands of investors. However, in debt mutual funds, AMCs pay Dividend Distribution Tax (DDT) from the distributable income at the rate of 28.345% (including surcharge and cess) (for Individuals and HUF investors). Interestingly, as far as effective tax rate on DDT is concerned, the effective rates are lower for investors as the DDT is calculated on actual dividend distributed and not on gross amount distributed (including the tax impact). But for an investor, the tax saved is calculated based on gross returns of his investment. For instance, out of Rs.1 of distributable income, the AMC has to pay DDT on the dividend of retail investors based on the following formula. That is (x + 28.33% of x = Re 1). Here, “x” denotes the dividend portion for retail investors. The result becomes (0.7793 paisa dividend + 0.2207 paisa DDT = Re. 1). Hence, the effective tax rate for retail investors (on the income distributed) will come close to 22.07% and not 28.33%. In a nutshell, we can say that the AMC has to pay 28.33% on the dividend of retail investors which is the same as 22.07% tax on the gross returns of the investment of the investors. (For further understanding you can access our earlier report “Change in DDT on Debt MF schemes from June 2013 onwards – How to cope”. Now the Union Budget proposes that the investors have to pay tax as 28.33%. Hence there is no effective tax benefit for investors. So the investor will lose out the benefit of the difference of the 6.26% (28.325% ‐ 22.07%). The Union Budget says, “…Therefore, the tax is computed with reference to the net amount. Similar case is there when income is distributed by mutual funds. Due to difference in the base of the income distributed or the dividend on which the distribution tax is calculated, the effective tax rate is lower than the rate provided in the respective sections. In order to ensure that tax is levied on proper base, the amount of distributable income and the dividends which are actually received by the unit holder of mutual fund or shareholders of the domestic company need to be grossed up for the purpose of computing the additional tax”. It can be explained with the example as shown in the Budget documents. Where the amount of dividend paid or distributed by a company is Rs. 71.68, then DDT under the amended provision would be calculated as follows: Dividend amount distributed = Rs. 71.68 Increase by Rs. 28.33 [i.e. (71.68*28.33%)/(1‐28.33%)] Increased amount = Rs. 100
  3. 3. RETAIL RESEARCH DDT @ 28.33% of Rs. 100 = Rs. 28.33 Tax payable u/s 115‐O is Rs. 28.33 Dividend distributed to shareholders = Rs. 71.68. 3. Marginal increase in the Government borrowing program: As per the proposals presented by Finance Minister Mr. Arun Jaitley, the gross borrowings of the government in 2014‐15 are pegged at Rs 6 lakh crore, 6.4% higher than the level in 2013‐14. In interim Budget (presented by Mr. P. Chidambaram on Feb 17, 2014), Gross market borrowing for 2014‐15 seen at 5,97,000 crore rupees, net market borrowing at 4,57,000 crore rupees, 5.9% higher than the level in 2013‐14. It is a marginal increase in the borrowing numbers compared to the interim budget. It is to be noted that if there is an upward revision in the borrowing program for this fiscal, then that will impact the bond market putting more pressure in the yields of the long dated securities. Meanwhile, government data show that India's fiscal deficit in the first two months of the 2014‐15 financial year touched 2,408.37 billion rupees ($40.05 billion), or 45.6 percent of the full‐year target. The deficit was 33.3 percent during the comparable period in the previous fiscal year. This means that the Government has already started spending heavily by touching half of the full year target in first two months in this financial. If this trend continues (and especially if the monsoon remains weak), the borrowings could be higher or front ended. Naturally, higher borrowing is negative for the bond market. This will lead spike in the yields of short as well as long term instruments. 10‐year Gsec yields could remain elevated in the near term. Short term rates also could be steady at higher levels despite the liquidity provided by the RBI through various measures. Considering along with the above mentioned fact, the possible acceleration in the domestic inflation on the back of below average monsoon or so called el nino effect, any potential geo‐political uncertainties and higher crude oil prices, we feel that the central bank will not refrain from cutting or raising the policy rates till October. There may be a cut in the second half of the fiscal with possible moderation seen in the inflation in the domestic economy. So, accrual funds such as Liquid, Ultra Short Term and Short Term Income Funds are suitable for any kind of investors. Low to Medium risk investors can consider short term income schemes which are maintaining modified duration not more than 2 years. Gross Market Borrowings by the Government over years (Rs in Lakh Crs): Source: Budget doc
  4. 4. RETAIL RESEARCH Contribution to Fiscal Deficit by Debt‐Market Borrowings (Rs in Lakh Crs): Source: Budget doc List of Government of India Securities maturing in 2014‐15: Nomenclature Date of issue Date of maturity Outstanding Stock (Rs. Crore) 7.37 % 2014 16-Apr-2002 16-Apr-2014 40,751 6.07% 2014 15-May-2009 15-May-2014 27,958 FRB, 2014 20-May-2003 20-May-2014 5,000 10.00 % 2014 30-May-1983 30-May-2014 1,404 7.32% 2014 20-Oct-2009 20-Oct-2014 13,000 10.50 % 2014 29-Oct-1984 29-Oct-2014 1,025 7.56% 2014 3-Nov-2008 3-Nov-2014 40,845 11.83 % 2014 12-Nov-1999 12-Nov-2014 5,042 10.47%2015 12-Feb-2001 12-Feb-2015 3,769 Source: RBI Analyst: Dhuraivel Gunasekaran (dhuraivel.gunasekaran@hdfcsec.com) RETAIL RESEARCH Fax: (022) 3075 3435 Corporate Office: HDFC Securities Limited, I Think Techno Campus, Building –B, ”Alpha”, Office Floor 8, Near Kanjurmarg Station, Opp. Crompton Greaves, Kanjurmarg (East), Mumbai 400 042 Fax: (022) 30753435 Website: www.hdfcsec.com Disclaimer: Mutual Funds investments are subject to risk. Past performance is no guarantee for future performance. This document has been prepared by HDFC Securities Limited and is meant for sole use by the recipient and not for circulation. This document is not to be reported or copied or made available to others. It should not be considered to be taken as an offer to sell or a solicitation to buy any security. The information contained herein is from sources believed reliable. We do not represent that it is accurate or complete and it should not be relied upon as such. We may have from time to time positions or options on, and buy and sell securities referred to herein. We may from time to time solicit from, or perform investment banking, or other services for, any company mentioned in this document. This report is intended for non‐Institutional Clients.

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