Budget 2019 Created Tax Arbitrage Between Debt AIFs and Debt MFs
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Steve Jobs once said, “There are downsides to everything; there are unintended consequences to everything.” The Union Budget 2019 was presented earlier by the Finance Minister with various proposals to guide India to a $5 trillion economy by 2024.

However, alternative investment funds (AIFs) and foreign portfolio investors (FPIs) in the country are experiencing the so-called ‘unintended consequences’ of the Budget the hard way.

Among the various amendments proposed in the Budget, there was one particular proposal which stood out – a plan to increase the marginal tax rates for the super-rich. Though AIFs and FPIs in India were not targeted in the Budget, the revision of the marginal tax rates is expected to burden these investment vehicles.

FPIs who invest in India are taxed as per individual tax brackets as the trusts or structures through which the investments are made considered as non-corporate entities under the Income Tax Act, 1961.

However, post Budget, FPIs earning less than Rs 5 crore will now have to pay a tax of 39% compared to 35.8% earlier. In the same line, the payable tax for FPIs earning more than Rs 5 crore has also been increased to 42.7% from 35.8% after the increase in the surcharge.

Since equity AIFs attract capital gains tax, these vehicles will not be affected by the increase in marginal tax rates. Debt AIFs, on the other hand, will be negatively impacted with interest income also being considered. The income generated from interest will now be clubbed with the additional income for which the marginal tax rates be applicable.

Apart from the high tax rates applicable to debt AIFs, another concern for individual investors is the tax arbitrage the Budget has created between debt AIFs and debt mutual funds (MFs).

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Debt AIFs generally require an investment amount of at least Rs 1 crore. Investors are right away added to the top tax bracket when investing in AIFs. When compared to debt MFs, debt AIFs are at a disadvantage when it comes to taxation,

While a dividend debt MF attracts a dividend distribution tax (DDT) of only 29.12%, a debt AIF will be taxed at 42.7% compared to the 35.8% it was taxed at earlier. This has lead to huge tax arbitrage of over 14% between debt AIFs and debt MFs.

Debt AIFs primarily target a higher yield to maturity (YTM) ratio. Since AIFs are high-risk investment vehicles, the returns generated are also higher. With the tax arbitrage in place, FPIs are in a dilemma as a portion of the returns from debt AIFs is now taxable. This can lead to investors reassessing their investments based on the risk-return dynamic.

Debt AIFs primarily invest in low-rated credit through financial intermediation. Since, these vehicles are high-risk investments, individuals with high net-worth form the investor base.

With debt AIFs attracting a tax of 42.7% compared to the DDT of 29.12% on dividend debt MFs, the investment market could see a massive transition of investors in the top tax brackets.

With debt AIFs and debt MFs being branches of the same tree – debt securities, a tax arbitrage between the two could most likely be one of the unintended consequences of the Budget.

Investors can only hope for the issue to be addressed and rectified soon. Clubbing debt AIFs with debt MFs under Section 115O of the IT Act can be a huge relief for individuals who invest their hard-earned money on high-risk investments.

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