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New tax rules- What this means for non-equity funds?
August, 05th 2014

The union budget 2014 has left non-equity fund investors perplexed, who are trying to figure out what the new tax rules means for them and how they need to strategize their investments to get tax efficient returns. For tax purposes, non-equity funds are those that invest less than 65 percent in equities. Some of the popular categories of non-equity funds are ultra-short term, short term, medium and long-term income funds, FMPs, debt –oriented hybrid funds like MIPs, gold savings fund, international funds as well as asset allocation funds. Investors in these funds will now have to pay long-term capital gains tax at the rate of 20 percent with indexation benefit on redemptions made after July 10, 2014. Moreover, they will be able to claim long-term tax benefit only if units are redeemed after 3 years and not 12 months, as was the case earlier.

This is certainly a step that would negatively impact investors who have non-equity funds as an integral part of their portfolios. Needless to say, investors in higher tax bracket of 20 and 30 percent will be impacted the most as short term capital gains are taxed at the maximum marginal rate of tax applicable to an individual. Considering that some of the categories of funds like short term income funds, income funds following accrual strategy and dynamic bond funds are ideal for a time horizon of 12-36 months, the revised tax rules will make a huge dent in their post tax returns.

Considering that a large number of investors in our country still prefer to invest in traditional options like fixed deposits, bonds and small savings schemes as these instruments offer guaranteed funds, there was a need to retain the tax efficiency of non-equity funds at least for individual investors to encourage them to invest in market linked products. Although debt and debt oriented funds are safer than equity funds, being market linked products, there is a certain amount of risk that investors take while investing in them. However, considering that these new tax rules have almost become a reality, investors need to understand their impact and be prepared to realign their portfolios, if required. Investors would do well to carefully deliberate the pros and cons of their decisions rather than rushing into doing something that can impact their portfolios adversely.

The right way to tackle the emerging scenario would be to work out a strategy for existing as well as new investments. All those investors, who invested in FMPs in July 13 and thereafter, can opt for rolling over their investments so that they complete 36 months in the scheme and become eligible to claim long-term capital gain tax benefits as per the new tax rules, provided the fund house is offering that option to them. More importantly, investors must be sure about not needing this money during the period for which the maturity date is being extended now. While by doing so, investors can avoid taking any interest rate risks, they must know that most of these FMPs will have a different investment pattern for the extended period. Besides, the expected returns from these FMPs for the extended period would be in line with the current interest rate scenario.

However, investors who may have invested in FMPs to benefit from the higher interest rates alone, the right way to make a decision would be to ascertain their time horizon afresh. In case the money is not required for say another five years or more, they can redeem their FMP investments and reinvest the money in either debt or equity oriented hybrid funds. For those who can remain invested for even longer periods, well diversified equity funds can be a good option. Remember, the key here is your time horizon and risk taking capacity. A similar strategy can be followed for fresh money to be invested.

A clearly defined time horizon always helps in making the right selection in terms of asset class as well as investment option. It is also important to remember that inflation is the major risk for long-term investments. Hence, the focus should on investing in an asset mix that can generate positive real rate of return.

For investors who are currently invested in open-ended income or debt oriented hybrid funds, the right thing to do would be to remain invested in them if they are sure about the selection of the funds as well as their suitability for their defined time horizon. Considering that most investors claim indexation while calculating their long-term capital gains to offset the effect of inflation, the new tax rules will not impact post tax returns on investments redeemed after 36 months or more.

Even while deciding on investment options for a time horizon of less than 36 months, investors must remember that mutual funds have the potential to provide better returns than traditional investment options, albeit with some amount of volatility. Hence, if one selects the right product and has some appetite for risk, the post tax returns can be still higher than traditional options and that too without compromising on the liquidity. In fact, for a time horizon of around one year or so, investors can opt for a tax efficient option like arbitrage funds.

As is evident, the current scenario requires investors to plan their investments well and opt for potentially better options like mutual funds. Although the new tax rules have taken some sheen out of non-equity funds, their potential to provide higher returns than traditional options remains intact.

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