The downtrend in the stock market, coupled with rising interest rates, has resulted in debt instruments gaining in popularity. Of course, debt instruments vary in terms of safety, coupon rates and liquidity. Even the term ?fixed income? is a misnomer, as this applies only to certain investments that are held to maturity, such as fixed deposits and debentures.
Here, the primary risk is of a default. Net asset value or NAV-based options such as debt mutual funds of all hues carry market risk and hence are not ?fixed? in the true sense. Besides the above-mentioned differences, investors should be aware of the difference in tax treatment for various debt instruments.
Fixed deposits and corporate debentures: Interest earned on these is taxed as per the investor’s income tax slab, thereby making it unattractive to investors in the highest tax bracket (30%). Besides, they also do not enjoy the benefit of being indexed to cost inflation. Hence, in the case of long-term fixed deposits or corporate debentures (maturing after one year or more), your principal amount actually loses value due to inflation. Many investors are unaware of this insidious side effect.
Government small savings schemes: Some of the popular avenues include post office monthly income schemes (POMIS), Kisan Vikas Patra (KVP), public provident fund (PPF) and National Savings Certificates (NSC). Currently, all of them are subject to administered interest rates. Hence, their popularity increases during low interest rate regimes. Here too, the tax treatment is not uniform.
Interest from KVP and interest and maturity bonus earned from post office monthly income schemes are taxed at the assessee?s income tax rate. Interest on an NSC is taxed on an accrual basis. However, the reinvested interest is eligible for tax benefit under Section 80C. PPF is the only instrument that enjoys zero tax levy at all levels ? investment, accumulation and withdrawal.
While interest on senior citizens’ savings schemes is taxed at the assessee’s rate, the burden for investors could be lower, as they usually receive this income after they retire and, consequently, their tax burden too has reduced.
Debt mutual funds: Being NAV-based, these are not fixed-income instruments in the true sense, thereby leading to some uncertainty in returns. They were viewed as instruments of tax arbitrage by corporates until the loophole with regard to liquid funds was closed a few years ago and for all other debt funds with effect from April 1, 2011.
Currently, a dividend distribution tax (DDT) of 30% is levied on dividends earned by non-individuals in debt schemes. Corporates usually use debt mutual funds to park short-term surpluses and hence do not prefer the ?growth? option. Even if they do, they usually sell within a period of a year. Hence, they will have to pay short-term capital gains of 30%. For individual investors choosing the dividend option, dividend distribution tax of 25% is levied on liquid funds and 12.5% on other debt funds.
Investors choosing the growth option can exercise the choice of paying either 10.30% or 20.60% long-term capital gains (LTCG) tax depending on two factors. One, in case they sell their units after a holding period of one year or more, or two, whether they choose to avail of the benefit of cost inflation indexation or not. There are two developments that have the potential to alter the landscape for debt instruments.
A recent Reserve Bank of India (RBI) committee set up for reforming small savings schemes has recommended that the current administered regime migrates to one where rates are market-determined.
The proposed new direct taxes code (DTC), slated to come into effect from April 1, 2012, subject to approval by Parliament, proposes to tax all income from debt mutual funds at the assessee’s tax rate. Also, while computing cost inflation indexation, the asset will have to be held for more than one year from the end of the financial year in which it was bought.
This proposal is bound to have a profound impact on providers of fixed maturity plans that may no longer be able to sell on the basis of the double indexation tax benefit they currently profess to offer. Hence, beware of mutual fund agents who try to sell you such schemes during the last quarter of this financial year.
The author is vice-president, Parag Parikh Financial Advisory Services
