Why investors favour debt PMS in light of taxation changes

Taxation in India especially is still evolving and so it brings opportunities and threats to the investment planning. The changes in taxation could make an existing investment attractive or disadvantageous and at times make an unattractive avenue till then advantageous. Though, taxation alone can’t drive your asset allocation decisions, one could use taxation to their advantage while making allocations. However, the asset allocation decisions should always be considered based on the risk profile, goals and timelines of the investor.

So, with the recent changes in taxation, even within the same asset class, the treatment turned differentiated. Earlier, the fund-of-funds which were investing overseas or even domestic equity markets were treated at par with debt taxation and so they seemed disadvantageous at least post-tax returns. This means that investors holding these assets or units over two years are considered long-term and attract 12.5 per cent on their gains versus their individual slab rates earlier. Now, with them being treated at par with the equity taxation, the capital gains rules make them attractive for investors.

Similarly, the case within debt assets. The debt mutual funds where predominantly the investments are based on debt instruments like bonds and t-bills is considered in the debt classification, the capital gains are taxed at the investor’s slab rates irrespective of the holding period. Capital gains are those sums where profits are generated over the principal at the time of divesting or redemption.

There’re two factors in a debt instrument, that is, a bond, one is the accrual i.e., nothing but the interest a bond generates, it’s the income. The other is the gains made i.e., when the sale of bond happens, the realised profit for the investor in the bond, from the mark-to-market (the bond price movement in the market). For a debt fund investor, as it is pool account both the income or accrual and bond price fluctuations matter less till one were to redeem. But, these are embedded in the NAV and so gets affected. The accrual or interest income is not seen as a separate component and so only worry is the taxation at the time of redemption on the capital gains.

The new tax rules, however, make a distinction on both these components if held through a debt PMS (Portfolio Management Service). While the interest earned i.e., accrual is taxed at marginal rates of the investor but the capital gains are treated different. The long term is considered as holdings of instruments 12 months and over and gains from these transactions are taxed at 12.5 per cent. This makes them highly attractive to those investors with higher capacities to invest. Because, the minimum investment for a PMS is Rs50 lakh.

Moreover, the market linked debentures (MLD) which are debt instruments, a type of non-convertible debentures but the returns are not fixed and are linked to the performance of the markets, mostly the index. The returns are dependent upon the underlying index, usually NSE Nifty or BSE Sensex, etc. and hence the name. So, there’s no income generated throughout the period till maturity and the return on the instrument is dependent on how the underlying index performed. Though, there’re a variation of principal protected MLDs, these were popular with the investors due their treatment at par with equity taxation. Now, they’re treated as debt instruments.

These instruments were also not for retail investors as the minimum investment was usually around 25L rupees. Now, with the new changes in taxation, debt PMS has acquired favor among these investors where the allocation remains pure to the asset while enjoying a substantially lower taxation on the gains.

(The author is a co-founder of “Wealocity”, a wealth management firm and could reached at [email protected])