Budget 2015 - interesting investment option for the HNIs

Here is the link to my article that appeared in Mid-day, Mumbai edition today.

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The English translation is as under:

28^th February is an important date in the life of many. This day, the Union Finance Minister presents Government of India’s budget to the Parliament. This process is telecast live and it is the most watched parliamentary sessions across the country. This year’s budget carried even more expectations from the people of India since this was the current Government’s first full budget after being elected to power.

People had voted this Government on the growth and anti-corruption agenda and hence the expectations were in line with this.

In this article, we will focus on two of the proposals of the budget, which may have an impact on the way one invests in the fixed income instruments.

1.     Introduction of tax-free bonds infrastructure for funding projects in the rail, road and irrigation sectors.

2.     Abolition of wealth tax, but increase in the surcharge on tax for those earning more than Rs. 1 cr.

Together, these two provisions mean that a wealthy person has lower tax burden but if the wealth generates taxable income, there may not be any net tax saving.

Almost all the income generating, safe investments offer interest income to the investor. This interest income is subject to tax at the nominal rate applicable for the said person. Someone in the highest tax bracket may be subject to highest tax slab for this interest income.

Thus, a wealth person may be best advised to invest such money in either the proposed tax-free infrastructure bonds or in growth plans of fixed income mutual funds.

Fixed income mutual funds invest in fixed income securities and like all other mutual funds, these also pass on the scheme returns as well as risks on to the investor. However, the current provisions of the Income Tax Act offer a huge advantage to investors in fixed income funds.

Any investor directly buying an interest-bearing investment has to pay income tax on the interest income (there are some exceptions e.g. tax-free bonds or PPF, etc.). However, a mutual fund is a tax-exempt entity and hence it does not have to pay tax on the income earned, even if it is in form of interest. This means, if one has chosen the growth option, one gets the benefit of compounding of income BEFORE tax. Over 10 – 15 – 20 years, this can be a huge gain.

At the same time, the mutual fund investor can decide which way one would like to receive the fund’s income – growth (capital appreciation) or dividend – we discussed about these options in detail in one of our earlier articles.

We recommend that the wealthy should consider investing in the growth option of fixed income mutual funds. The fund’s NAV would continue to grow based on the internal earnings of the fund as well as the changes in the market value of investments. If one has a long time horizon (it is fair to assume that one would have a long time horizon for certain investments, since many investors invest their money in PPF (15 years) or the tax-free bonds (10 to 15 years)), the short-term fluctuations in the NAV of debt funds should not be of any concern.

The investor can withdraw any amount of money (subject to balance in the investment folio) whenever one needs it. Such withdrawal may generate capital gains (profit) for the investor. If the withdrawal were after more than three years from the date of investment, the capital gain would be considered as long-term for the purpose of taxation. This means, the profit would be subject to long term capital gain after adjusting for indexation. In most cases, such tax is likely to be very low. Let us look at the calculation of the capital gains by taking an example (all the dates and numbers in this example are only for illustration purposes):

·      Investment of Rs. 10,00,000 in XYS short-term income fund on 1 January, 2011, when the scheme NAV was Rs. 20

o   Hence, the investor was allotted 50,000 units (Rs. 1 lac / Rs. 20)

·      A sum of Rs. 50,000 was withdrawn from this investment folio on 3 March, 2014 when the NAV was Rs. 26

o   The investor redeemed 1923.077 (Rs. 50,000 / Rs. 26)

·      The capital gain was equal to number of units redeemed multiplied by the difference between the prevailing NAV and the purchase price, i.e. 1923.077 units X (Rs. 26 – Rs. 20) = 11,538.46

As one can see, the accounting of the income funds is such that the entire withdrawal is not the taxable income. The capital gain is only a small part of the amount withdrawn. Hence, the investor can take money out of the investment as and when required and still enjoy lower taxes. At the same time, till the time money is not required, the income compounds at before tax rate.

It is worth considering investing in fixed income mutual funds in light of this provision. However, one would recommend an investor to understand the fixed income mutual funds well before investing.

Amit Trivedi

The author runs Karmayog Knowledge Academy. The views expressed are his personal opinions.