Would AIFs (Alternative Investment Funds) gain favour as debt funds lose long-term tax benefits?

Investors are puzzled about whether to purchase debt mutual funds before March 31st because the indexation benefit would end starting from April 1, 2023. Alternative Investment Funds (AIF) are predicted to soar, despite the absence of the long-term tax benefits that debt mutual funds had previously enjoyed. Let's hear thoughts from our sector experts based on an exclusive interview on whether AIFs may replace debt mutual funds after the indexation benefit was removed on such products as of April 1.

Suresh Surana, Founder, RSM India

The original Finance Bill 2023 proposed to insert a new section 50AA to tax capital gains on transfer or redemption or maturity of the market-linked debentures as short-term capital gains taxable at the marginal slab rates applicable to the taxpayer. For the purpose of such computation of capital gains, the full value of the consideration received or accrued as reduced by the cost of acquisition and the expenditure incurred wholly or exclusively in connection with transfer or redemption of such debenture shall be considered as capital gains arising from the transfer of a short-term capital asset.

The amended Finance Bill as passed by the Lok Sabha on 24th March 2023 extended the scope of Section 50AA to specified mutual funds where not more than 35% of its total proceeds is invested in the equity shares of domestic companies i.e. covering debt mutual funds which have less than 35% equity holding. Prior to such proposed amendment, such debt fund units held for more than 3 years would be taxed @ 20% after availing the indexation benefit. However, in accordance with the proposed amendments, the same would be subjected to tax as per the marginal slab rates applicable to the taxpayer.

Parry Singh, Founder & CEO, Red Fort Capital

Due to the challenging performance of debt mutual funds in a rising interest rate scenario - particularly those with longer duration bonds - HNIs and investors may consider exploring Alternative Investment Funds (AIFs) as an alternative. In 2022, debt funds delivered meager returns due to a sharp increase in interest rates. 

AIFs, encompassing private equity funds, venture capital funds, and hedge funds, have the potential to offer better returns and tax efficiency compared to traditional debt mutual funds. Nevertheless, AIFs carry their own risks and are generally less liquid than debt mutual funds. Before deciding to shift their investments, investors should thoroughly assess the risks, rewards, and suitability of AIFs within their portfolio.

Umesh Salvi, Managing Director, Catalyst Trusteeship Limited

As per the 45 recent amendments passed by the government in the Lok Sabha, the Amendment - “Finance bill 2023” states that capital gains coming from the debt mutual funds will only be considered as short-term capital gains from April 1, 2023. Meaning that any earnings from debt mutual funds held for a period of fewer than 3 years or more will now be added to the taxable income of the investors, bringing the rate of gains equal to FDs (Fixed Deposits). 

The aforesaid Amendment will lead some high-net-worth individuals and investors to explore alternative investment options, such as Alternative Investment Funds (AIFs) due to the various taxation benefits it holds along with being the most flexible & diverse investment option. It provides HNIs with exposure to alternative assets that can potentially offer higher returns by helping them take advantage of market opportunities. 

AIFs may also offer tax benefits to investors, such as tax exemption on long-term capital gains, which can help to reduce the tax burden for HNIs & Investors as it offersgreater flexibility and diversification than traditional mutual funds and offers investors the opportunity to invest in a wide range of assets, including real estate, private equity, venture capital, and distressed assets.

Thus, it sums up by saying that investing in AIFs would be the need of an hour for HNIs, and other investors for earning greater returns along with numerous taxation benefits both at the Domestic and International level through IFSC, GIFT City.

Vinayak Magotra, Founding Member, Investment Product, Centricity Wealthtech

The recent tax changes on debt mutual funds will lead to a higher degree of acceptance amongst investors for alternates, especially through the AIF route.

AIFs offer a range of advantages, including diversification and greater flexibility in investment strategy. Fixed income AIFs can participate in high yield credit opportunities, venture debt, revenue backed lending opportunities, structured debt, and curated special situations transactions to generate higher risk adjusted returns. 

These benefits and hitherto unexplored fixed income strategies may appeal to high-net-worth individuals and large family offices to supplement their mutual fund holdings and improve their post-tax risk adjusted returns. However, it is important to note that AIFs also come with their own set of risks including a higher minimum threshold.

Investors should carefully evaluate their investment goals and risk tolerance before considering AIFs as an alternative investment option. It is also important to seek the guidance of a qualifies financial advisor to ensure that the investment aligns with their overall financial strategy.

Nilesh Dhedhi, Fund Manager, Avendus Structured Credit Fund

The new norms have made the tax treatment same for debt MFs and debt AIFs. Now, the investors are likely to make portfolio allocation basis their investment objectives and the risk & return matrix of the asset class without tax considerations. 

This should allow for the introduction and expansion of multiple products operating/investing within the Performing Credit spectrum with different yield buckets (12-18% IRR),  which earlier were not as commercially attractive for HNI investors on a post-tax basis compared to the debt MFs. 

Over time, this may also create a way for debt AIFs and other debt yield products to become part of the mainstay fixed income investment allocation rather than be seen as only a part of Alternate investment category.

Dipen Ruparelia, Head-Products, Vivriti Asset Management

Investors were so far attracted to debt MFs due to the underlying papers rated AA and above in addition to the benefit of indexation if the holding period is 3 years or beyond. As the indexation benefit will no longer be available post 1 April 2023 and given the high spread between A and below assets vis-à-vis AA and above instruments, there would be a tendency amongst HNIs/family offices to look for credit AIFs, which offer high-yielding returns.

The budget provides the long-awaited level playing field required amongst all asset managers in the debt space, irrespective of the vehicle (MF, PMS, or AIFs) under which this is managed. Dipen Ruparelia, Head of Products, Vivriti AMC believes that well-managed credit AIF managers are well placed to benefit from this change as now the true comparison will be purely on risk v/s reward rather than post-tax returns (which wasn’t much under the control of the asset manager per se). Our products, now offer a pre-tax, (post fees and expenses) spread of up to 7% as compared to AAA focused MFs.

Pradeep Gupta, Senior Director- Investments, Lighthouse Canton

This is certainly a big surprise and perhaps comprehending overlapping impacts will eventually come with time. Despite massive growth exhibited by the mutual fund industry in recent years, our AUM to GDP ratio is still nowhere close to the global average and such policy distortions don’t augur well for the industry at large. Given that tax parity is taken away, it is likely to halt the pace of deepening of Debt Mutual Funds share vis-à-vis conventional fixed deposits or other traditional avenues. Mind you, the case for diversification, better-managed risk, and flexibility on offer by debt mutual funds continues to remain intact.

Advisors and Investors will have to alter their assessment framework to look at the overall appeal of a fixed-income proposition on a pre-tax basis along with the risk-reward spectrum on offer.

Mainstreaming of performing and private credit was already underway and this move is likely to increase their overall acceptance. Long/Short and Absolute return strategies with Debt plus kind of mandate will continue to gain ground albeit at a higher pace now. Expect a slew of launches by fund houses within the hybrid fund category which will navigate around regulatory lines. Such funds certainly make asset allocation tricky for an investor and call for reorienting the overall thought process since mutual funds don’t get tax impacts while taking tactical asset class bets within the scheme.

We still haven’t done the requisite justice to DIY investing platforms when it comes to fixed income as an asset class. This move is likely to channelise the right effort and bring requisite synergy to have one in the near term. While a lot of work is required to make investors attuned to associated risk around intrinsic credit profile, duration, liquidity, etc.

The criticality of mutual funds in the development of the corporate bond market was never understated given their role in providing a stable and alternative source of bank financing. With heightened uncertainty around debt mutual funds flows going ahead, the availability of risk capital with stitched flexibility can get difficult to come by for these corporates thus hardening the bargaining terms. NBFC’s and HFC’s too will have to come out with sustainable and alternative ways of raising capital.

Sujit Bangar, Founder, Taxbuddy.com

AIF cannot be compared with debt mutual funds. AIF comes with higher risk and totally different asset class. Tax blow to debt mutual funds is very harsh but it’s unlikely to see investment flow to AIFs.

Vineet Agrawal, Co-Founder, Jiraaf

Debt Mutual funds currently provide two great benefits to investors. One is the Long-Term Capital Gain (LTCG) tax benefit of only 20% with an indexation benefit if sold after holding the funds for at least 3 years. Second is the indexation benefit wherein if the annual Pre-Tax return is 10% and inflation is 7%, you pay taxes only on the incremental return over inflation, which in this case is just 3%. 

So, in total your net tax is 20% * 3% = 0.6% of the returns. Your post-tax return in our example will be 9.4% (10%-0.6% in taxes). Fixed Deposits in comparison are taxed based on individual tax slabs with 30% being the tax rate for investors earning an annual income of more than 10 lakhs.

Last week, the government has updated the Finance bill to scrap this benefit on investments starting April 01, which means the returns would be taxed at income tax slab level like Fixed Deposits.

Jiraaf believes that this move will impact the debt industry and could influence fund movements into equity and FD products. We do recommend investors to add Alternate Fixed Income products such as unlisted corporate debt, asset leasing, invoice discounting, venture debt, etc. to their portfolio (10-20% allocation) as these products typically have lower risk than equity products and can provide good post-tax inflation-beating returns. 

But overall, this change will impact the mutual debt fund industry, corporations who look to raise debt through bonds, and investors. Banks could see an increase in both FD inflows and corporate borrowings with this policy change.

Raj S Inamdar, Partner, TriVeda Capital

While the removal of long-term tax benefits of debt mutual funds was unprecedented and may reduce this category's popularity, HNI’s and investors may look at Alternative Investment Funds (AIF) as a preferred investment vehicle. 

AIFs are an attractive way for HNIs to diversify their portfolios as they are SEBI regulated, and offer a variety of investment themes and tax-friendly structures. The Indian government's actions may shift asset allocations to AIFs, and investors will continue to have access to tax-friendly structures via AIFs.

Khazana Associates founder Santosh Badhei

High net worth individuals (HNIs) are likely to invest their money in the equity savings category and the balanced advantage category, and some amount may also go towards alternative investment funds (AFIs). On the other hand, retail investors are expected to put their money into non-convertible debentures (NCDs) and fixed deposits.

Mr. Edul Patel, Co-founder and CEO at Mudrex

Given the recent tax changes affecting debt mutual funds, some high net worth individuals and investors may opt for Fixed Deposits (FDs) that offer tax benefits. Alternative Investment Funds (AIFs) may be perceived as risky, and therefore, not a suitable alternative for some investors.

Rahul Jain, President and Head, Nuvama Wealth

Investors, particularly HNIs, opted for debt funds for relatively higher post-tax returns due to concessional taxation, primarily because of the indexation benefit. In the absence of indexation benefit, HNIs will focus their attention on other investment opportunities, such as private and structured credit, stressed assets, and infrastructure space, which are accessible only through alternative investment funds (AIFs).

Neha Juneja, CEO, IndiaP2P.com

The removal of indexation benefits has effectively brought debt mutual funds and fixed deposits are par.  This means that HNI investors will have to seek out returns on debt instruments at higher risks leading to greater interest in the corporate bond market and debt AIF schemes. 

Debt AIFs are already seeing increased interest from HNIs and Family Offices due to the promise of low to mid-teens, fixed-income returns on high-yield debt, making them more attractive than traditional bonds. With this change to debt mutual funds we are also likely to see more debt AIFs launch schemes tailored to the investors with lower risk profiles.

CA Niyati Mavinkurve

I believe this move was done to get more tax out of HNIs and other larger investors. Even then, considering the present AIF taxation structure, the HNI's will only benefit if they invest in Category III AIFs since Category I and II are taxed at the investor level. So, even for HNIs, they will need to figure out where the AIF invests and then only check their allocation of funds. Another outcome of this rule could possibly push HNIs and other investors to invest in bonds directly via the RBI Retail Direct platform. 

The finance bill particularly spoke about removing LTCG on debt mutual funds. The same benefits extend to direct holding of bonds. So, a smarter or savvy investor may shift to holding bonds directly in their portfolio as compared to holding them via a mutual fund. Perhaps this may give rise to portfolio managers who offer PMS schemes particularly in the debt market. It is yet to be seen how the whole move plays out and how it impacts the market. Nithin Kamath from Zerodha wrote a very insightful thread about this on Twitter.