All about the Finance Bill tax googly for debt funds and derivatives

Investors had breathed a sigh of relief after Union Budget 2023 as there were no new taxes announced. But that relief was short-lived as the finance bill passed last Friday had many new amendments and a host of new tax measures were incorporated.

The tax measures pertained to mutual funds from the debt, international, gold and conservative hybrid categories – their indexation and long-term capital gains definitions were removed. All debt funds would now be similar to fixed deposits on tax treatment.

A small window is open for debt fund investors to invest till March 31, though that may not be the best way to go about making asset allocation decisions.

Another new rule pertained to the increase in securities transaction tax (STT) on futures and options trading.

One relief measure was the rolling back of the tax on the return of capital component of REIT (real estate investment trust) pay-out that was announced in the Union Budget.

Here’s more about the finance bill amendments and how it would affect investors starting from the new financial year.

Tax shock in finance bill

The total debt fund assets in the industry are around Rs 12.3 lakh crore as of December 2022. A little over Rs 33,000 crore of that is made up of retail investors, according to data from mutual fund trade body AMFI. HNIs hold around Rs 3.36 lakh crore in debt funds. As a percentage of total folios, 67% of debt-oriented schemes and 76.7% of liquid and money market funds are held by retail investors.

The finance bill passed with amendments states that mutual funds that invest less than 35% in Indian stocks and are referred to by whatever name would lose the indexation benefit. Further, there would be no differentiation between long and short-term capital gains and all profits would be treated at short term and taxed at the investor’s slab.

The reference to “less than 35% investment in Indian stocks” brings many categories within it – all debt funds, global fund of funds (as they invest overseas entirely, conservative debt funds as they invest less than 35% in Indian equities and gold funds (because they invest only in gold). Gold funds that invest in gold mining stocks overseas would also obviously be included in the list.

However, only investments made on or after April 1 would the new tax system apply. For existing investments and those made till March 31, the old tax rules with indexation and long-term capital gains would continue.

Until now, gains from debt funds made from a holding period of over three years were classified as long-term and were eligible for indexation, or adjustment of gains against inflation. The capital gains tax for the long-term profits was 20% with indexation and 10% without indexation.

Now, however, any gains – short or long term – will be taxed at your slab, with no indexation benefit.

Target maturity funds, which had almost no credit risk and very little interest rate risk if held till maturity, would be one of the most affected as these have over Rs 1.2 lakh core assets under management.

This would be clear from the illustration below.

Let’s say a debt fund gives 7.5% returns on a compounded annual basis over five years. Also, suppose the inflation rate is 6% on an average over this period. If indexation is taken into account, the effective post-tax return would be 7.0%. But under the new rules from April 1, for any debt fund investments made, the effective post-tax returns would be 5.4% for a person paying 31.4% tax (30% plus 4% cess).

The one key advantage that debt funds still have despite the new rules is that taxes are to be paid only upon sale of units. So, you can defer taxes by postponing your selling decision.

This is the one positive for debt funds compared to fixed deposits and other small-savings investments offered by the government.

On gold, interest may increase in sovereign gold bonds as they offer a fixed interest of 2.5% and the capital gains are tax-free if held for eight years till maturity.

STT on futures and options hiked

Given the soaring volumes in the futures and options segment, the government has thought it fit to milk it more for taxes.

In the last 10 years, F&O volumes have surged by almost 50 times. In the 11 months of FY23, the total volumes were Rs 33,268 lakh crore.

Therefore, the Finance Bill has proposed increasing of securities transactions tax (STT) on sale of options and futures steeply.

The STT on options is increased from 0.05% currently to 0.0625% from April 1. On the sale of futures, the STT has been increased to 0.0125% from 0.01% presently.

These can be illustrated with a couple of examples.

Let us say, you are selling ten lots of Nifty 50 futures at 17,000. The lot size is 50. So, the new STT would be:

17,000*10*50* 0.0125% = Rs 1062.5, rounded to Rs 1063. The STT would have been Rs 850 had the rate remained 0.01%.

In the case of selling options, assume that you sell the Nifty index option premium for Rs 100. Let’s say you sell 10 lots. The lot size is 50. The new STT would be:

100*10*50*0.0625 = Rs 31.25. Had the STT remained at 0.05%, you would have paid Rs 25.

However, ‘in the money’ options that are exercised upon expiry will continue to pay 0.125% of the intrinsic value, just as it they are now. There is no change there.

The increase in STT on futures and options trading means that high frequency traders would have work with even lower margins than the wafer-thin levels at present.

REIT tax relief

After making all payouts of REITs taxable in the Union Budget, the Finance Bill seems to have softened the stance on the product.

Now, REITs make payouts to unit holders under different heads: interest, dividend, rental income, and repayment of debt. Of these interest, dividend and rental income were made tax free, while repayment of debt was made taxable in the Union Budget. That clause is now removed.

Currently, payouts under the ‘repayment of debt’ category represent 45-90% of most REIT payouts.

The REITs of Mindspace Business Parks, Brookfield India and Embassy Office Parks give 5.5-7.5% dividend yield currently. Had the entire payout suffered tax, HNIs who fall in the highest tax brackets would have seen the yields on REITs shrink to 4.5% range.

Thus, REIT investors can look forward to continuing good yields as earlier.

However, there is one condition mentioned in the Finance Bill on REIT taxation. If the cumulative dividend payout under all heads exceeds the issue price at some stage over the years, the incremental amount would become taxable at your applicable slab.

For example, let’s say a REIT is issued at Rs 100 in 2020 and over the years, it makes regular dividend payments and by, say 2033, the total dividend paid over the 13 years becomes Rs 120. Then, Rs 20 (120-100) would be taxable. If the dividend paid in 2034 is Rs 15, then that incremental Rs 15 would be taxed at your slab rate.