Wealthy investors may bet on debt MFS

Budget proposal to tax PF interest is the trigger: Experts

Wealthy investors who used to park excess money in their voluntary provident fund (VPF) accounts may look to reallocate some of the corpus to debt mutual funds.

Under the existing tax provisions, interest on provident fund (PF) is exempt from tax. However, in the Union Budget for 2021-22 the government has proposed that interest on PF contributions (employee contribution) above ~2.5 lakh per annum will be taxable with effect from April 1.

This proposed change might impact employees in higher income bracket or those who make large contribution to VPF. Assuming basic salary is 50 per cent of total remuneration, employees with a salary of ~41 lakh and above per annum will be impacted, reckon experts.

“Optically, the number of options for investors may appear to be many. However, when you consider parameters such as tax benefits, compounding of returns, reinvestment risk and credit risk, it whittles down to a few,” said Aashwin Dugal, co-chief business officer, Nippon India Mutual Fund.

He believes that certain types of debt mutual funds that offer a suitable mix of benefits such as high credit, liquidity, compounding and long-term taxation on capital gains, may become attractive to such investors.

“While investment in debt funds comes with much higher risk, wealthy investors will have no choice but to explore this option to lower their tax burden and maximise returns,” added Swarup Mohanty, CEO, Mirae Asset MF.

Currently, rate of interest on EPF/VPF is 8.5 per cent for FY20. Considering a 30 per cent tax rate and a cess of 4 per cent, employees would get a post-tax interest of 5.8 per cent on EPF/VPF contributions (employee contribution) over ~2.5 lakh per annum.

The Employees’ Provident

Fund Organisation (EPFO) may lower the interest rates for FY21 in its Central Board of Trustees (CBT) meeting scheduled for March 4 from the existing 8.5 per cent in view of higher withdrawals and lower contribution by members this fiscal, according to reports.

Six debt categories have given returns between 7.1 per cent and 7.6 per cent in the past year. Long-term capital gains for debt funds for a holding period of three years and above are taxed at 20 per cent with indexation.

Since EPF/VPF investors are used to stable returns over long periods, equity or real estate are ruled out, said Dugal. Earnings on other options such as NSC, post office and Reserve Bank of India bonds have become taxable. The government is not issuing tax-free bonds and those available in the secondary market are yielding returns of 4.5-5 per cent, he said.

The Union Budget has proposed enabling retail investors to buy G-secs in smaller lot sizes, but the coupon that is paid by the bond issuer is taxable in the hands of the investors. MF schemes do not attract tax of coupon payment by the bond issuer.

“Investors could consider long duration gilt funds, especially schemes that offer the benefit of duration roll down, which essentially means the scheme is reducing its duration constantly by continuing to stay invested in the same security. Any incremental flows to the scheme are invested into same security. The concept is similar to holdto maturity. We have a fund called Nivesh Lakshya Fund that broadly works on this concept,” said Dugal.

However, some experts believe that with interest rates unlikely to soften from here on, the possibility of debt funds fetching returns of over 7 per cent looks unlikely in the near term.

“Investors might gravitate towards NPS, which seems like a better long-term option, despite the tax treatment at the withdrawal stage. It facilitates investments under the active or auto mode, with the former allowing investors to switch from equity to debt and debt to equity,” said Prateek Pant, co-founder and head of products and solutions, Sanctum Wealth Management.

Contributions to NPS are tax deductible up to ~1.5 lakh under Section 80C and up to ~50,000 under Section 80CCD(1B). Returns are market linked and have varied from 9-16 per cent, depending on the type of funds invested in. Sixty per cent of the NPS corpus is tax-free and the rest goes into buying an annuity, which is taxable.

According to reports, the top-20 HNIS had about ~825 crore in their PF accounts, while top-100 HNI contributors had in excess of ~2,000 crore.