'A sharp fall in bank, non-bank deposits may have led to change in debt MF tax rules'

An 11-percentage-point drop in the share of bank and non-bank deposits in total savings pool between FY19 and FY22 may have led to the government yielding to the banks’ call for level playing field in taxation of debt mutual fund instruments.

The policy move can also be seen more as an effort to curb tax arbitrage, analysts said.

Based on gross savings flows data, the share of deposits reduced to 27% in FY22 from about 38% in FY21, while the share of provident funds has increased to 22.7% from about 19% during the same period. Flows in mutual funds have risen sharply to 6% in FY22 from an average 2.4% in FY19-21, ICICI Securities said in a note.

“We expect about ₹4 lakh crore of debt AUM to see the highest impact due to removal of tax indexation benefits. Based on our assumption, we expect flows of any debt mutual fund scheme having an investment horizon of more than three years to be impacted due to the recent amendments to Finance Bill 2023,” research analysts Ansuman Deb and Ravin Kurwa of ICICI Securities said.

The ₹4 lakh crore sum does not include AUMs of liquid, overnight and other shorter duration funds.

“The withdrawal of indexation of debt fund gains can be seen more as a concerted attempt to move away from tax arbitrage and create a level playing field. Hopefully, tax rates will also be reduced over time to adjust for inflation,” Bank of Baroda chief economist Madan Sabnavis said.

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“Our discussions with debt market participants and bankers suggest an arbitrage-sensitive capital pool of ₹2-3 lakh crore,” research analysts with HDFC Securities — Sahej Mittal and Krishnan ASV – said.The levy of marginal tax and the removal of indexation benefits have made post-tax returns of debt MF schemes similar to bank FDs and other products.

“As a result, we could see some transition of money from debt MFs to bank FDs and other products,” Motilal Oswal said. However, it expects marginal benefits for the banking system, as long-term debt schemes have a total AUM of ₹8 lakh crore against banking system total deposits of ₹178 lakh crore and and fixed deposits of about ₹100 lakh crore.

Despite the tax related move, debt mutual funds will enjoy benefits such as better liquidity since early withdrawal of bank deposits attract a penalty. Again, tax on interest is paid upfront in FDs, while tax on debt MF schemes is on redemption.

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