The government has proposed a major shake-up in the taxation of debt mutual funds with the introduction of the Finance Bill 2023. Under the new amendment, capital gains arising from debt mutual funds will no longer be classified as long-term capital gains, but instead as short-term capital gains.
This means that any gains arising from debt mutual funds will be added to the investor's taxable income and taxed at their income tax slab rate. The proposed changes, once approved by the parliament, would be applicable to investments made on or after April 1, 2023.
This proposed change will no doubt have a significant impact on the investment landscape, and investors should be prepared to make adjustments to their portfolios in order to stay compliant with the new taxation rules. Let us understand its specifics in detail.
What are debt mutual funds?
Debt mutual funds are an attractive investment option for those who are looking for a secure source of income. They are a type of mutual fund that invests primarily in fixed-income instruments such as bonds, corporate debt securities, government securities, and money market instruments.
They are particularly popular among investors who are looking to diversify their portfolios and protect their capital. Due to their low risk and attractive returns, these funds are a great way to generate passive income and build wealth over the long term. Moreover, they provide investors with the flexibility to rebalance their portfolios and make necessary adjustments as per market conditions.
What are the current tax benefits for investing in debt funds?
Currently, one of the biggest reasons for investing in debt funds is the tax advantage they offer over fixed deposits. If a debt fund is held for more than 3 years, the investor pays long-term capital gains tax at 20 percent with indexation benefit while interest from the fixed deposit is taxed as per one's tax slab.
Hence, the post-tax returns for debt mutual funds are higher than the post-tax returns of bank FDs. The short-term capital gain from debt funds, however, is currently taxed as per individual tax slab if redeemed before 3 years.
What are the proposed changes?
The Indian government is moving to treat gains arising from debt mutual funds as short-term capital gains via an amendment to the finance bill. The change, if approved, would result in the loss of significant benefits available to investors in the form of indexation on long-term capital gains.
Mutual funds with less than 35% invested in equities are proposed to be treated as short-term and the indexation benefits that help significantly reduce tax liability available to such funds may be removed prospectively. As such, the tax rate applicable would be based on the income tax slab in which the investor falls. This could reduce inflows in debt mutual funds and benefit bank deposits.
What does this mean for debt fund investors?
This finance bill amendment to end LTCG tax benefits implies that regardless of the holding period, investors will have to pay tax at their applicable slab rate, instead of the current tax rate of 20% (with indexation).
Without favorable tax treatment, the case for debt funds almost goes away. This could potentially reduce the attractiveness of debt mutual funds as an investment option for investors. It could also result in investors shifting their investments to other instruments such as fixed deposits and small savings schemes.
This proposal will also affect international funds and gold funds/ETFs that are taxed as debt funds. It will make buying physical gold more tax efficient (apart from Sovereign Gold Bonds) than gold ETFs and direct foreign stocks/ETFs through liberalised remittance scheme more tax efficient than feeder funds.
There are certain benefits of debt funds that still make them marginally better for some people, such as no tax till redemption as compared to FDs that are taxed on an accrual basis, flexibility to withdraw or invest as much as one wants anytime without any premature termination penalty, and the ability to set off and carry forward capital gains and losses.
The proposed changes to the finance bill could have a significant impact on debt fund investors. It could potentially reduce inflows in debt mutual funds and benefit bank deposits. Investors should evaluate their investment strategy and decide if they should continue to invest in debt mutual funds or shift to other instruments.