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Posted by: Uma Shashikant on Sun, Aug 3rd, 2014

Debt Funds and FMPs- What Now? Part 2- Why Tax Can't be Avoided

Last week I wrote a blog about the new effective date for capital gains tax treatment of debt funds. After writing about FIFO method for capital gain computation, I put in a table showing how the actual tax outgo in a SWP would be lower.  That was not a complete and correct representation. Except for quiet shares in Facebook without any comment, and RTs in Twitter without discussion, there was no response.  No one wrote to me either. My sense is that readers would have wondered that something is wrong in the table. Well, teachers make mistakes and the readers are too gracious.


Yes, that was regrettably a partial and untrue story. The complete story is in the table below:


capital gains tax treatment of debt funds


This is a bit more detailed and assumes a 0.0833% return per month (10%/12 months) and the increase in NAV reflects that. The SWP is constant, until it falls below the value of Rs.3 lakh and is fully redeemed. The result will not alter unless the SWP is extended beyond 36 months. The investment value is balance units times NAV; balance units is after reducing units amounting to (STP amount/NAV); and capital gains are redemption value less cost of redeemed units.  


When one invests Rs. 30 lakh in a debt fund (first line) and begins an STP, the withdrawal does not get fully taxed, as is the case with a bank deposit. That is because each withdrawal has one portion as capital and one portion as income. Only a part of it is capital gain, and will be taxed.  Recall that I also wrote that taxation will be on first in first out basis. This means, as the investor draws money over time, the cost remains Rs. 10 per unit, but as the NAV grows the gain grows.  The sum total of capital gains tax, when the entire amount is withdrawn (last row) is the same as if the total of invested amount plus gain was withdrawn in one lump sum.  The small amounts of capital gains tax will grow, and add up, such that the gains from SWP/STP equal the gain from a lump sum income as in a bank deposit. There is no real tax advantage in a debt fund, if the withdrawal is before 36 months.


To those that still refuse to give up, there are two options:

1. If the first SWP is after a lapse of a period of 36 months, the indexation benefit will kick in.

2. If the investor does not redeem the entire amount, and if the SWPs spill over into a period   greater than 36 months, there will be a benefit of lower taxes for those SWPs


The summary therefore is, for all redemptions from a debt fund (SWP, STP, switch, maturity) which happen before a period of 36 months, the amount of tax an investor will pay is the marginal rate applicable to the investor. 


It is time to give up the tax arbitrage and focus on the real merit. The access to debt markets, the lower risk of a portfolio, the lower cost compared to a high spread of other intermediaries, the benefit of total return from marking to market, the flexibility of easy investment and withdrawal, and the professional management of credit and interest rate risks are all significant merits to invest in a debt fund. 

Sasi Kanth G on Wed, Aug 6th, 2014 9:08:38 pm

Thank you for the full working.

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