Introduction
The taxation of Debt Mutual Funds has been a topic of discussion for the past few days, with several amendments being made to the rules and regulations surrounding it. The proposed changes seem to bring taxation of specified debt mutual funds on par with bank deposits, providing the government to tighten the arbitrage being used by HNIs to reduce their tax outgo. In this article, we will explore the amendment made in the taxation of specified Debt Mutual Funds and their impact on investors.
What are Debt Mutual Funds?
To understand the changes made in the taxation of specified Debt Mutual Funds, we must first understand the concept of debt mutual funds and the existing tax structure thereon. These are investment vehicles that primarily invest in fixed-income securities such as bonds, debentures, and other debt instruments. The returns on such investments are typically in the form of interest payments or capital appreciation, making them an attractive investment option for conservative investors.
Existing taxation of Debt Mutual Funds
Until the recent amendment, the taxation of debt mutual funds was governed by the rule of indexation and period of holding.
(A) Short-Term Debt Mutual Fund: If the debt mutual fund scheme unit is redeemed on or before the completion of 36 months (three years), then the gains on the units are called short-term capital gains. These short-term capital gains are taxed at tax rates applicable to your income.
(B) Long-Term Debt Mutual Funds: However, if the holding period exceeds 36 months, then gains are called long-term capital gains (LTCG). These long-term capital gains are taxed at 20% with an indexation benefit. In other words, this meant that the gains made by investors were adjusted for inflation, reducing the tax liability on the investment.
Proposed Amendment in Specified Mutual Funds (‘SMF’) and its impact
As per the amendments made in Budget 2023, no benefit of indexation for the calculation of long-term capital gains on Specified debt mutual funds (i.e debt mutual funds where the equity portion of the mutual fund scheme does not exceed 35%) will be available for investments made on or after April 1, 2023. In a nutshell, it will be taxed as per applicable income tax rates to your income slab.
Apart from this, indexation benefits will not be available in the case of LTCG on gold mutual funds, international equity mutual funds, fund of funds, and hybrid mutual funds as well. Additionally, the mutual fund houses are also likely to be adversely impacted as the investors may prefer to invest directly in the debt securities rather than the debt mutual funds to avoid AUM fees/charges.
This change may impact the attractiveness of debt funds as an investment option, as the tax burden on the returns may increase.
How proposed changes would impact tax outflow:
Let us understand this with an example:
Suppose, Mr. A had made an investment of Rs. 10,00,000 in FY 2014-15 and had sold such investments post 3 years of holding period in FY 2021-22 for a sale value of Rs. 18,00,000, thereby earning a capital appreciation value of Rs. 8,00,000.
| Financial Year | Cost Inflation Index (CII) | Amount (Rs.) | |
| Investment Made | 2014-15 | 240 | 10,00,000 |
| Sale Consideration | 2021-22 | 317 | 18,00,000 |
| Indexed Cost of Investment | (10,00,000*317/240) | 13,20,833 | |
| Long Term Capital Gain (LTCG) | (18,00,000-13,20,833) | 4,79,167 | |
| Tax Liability | 20% of 4,79,167 | 95,833 |
Tax Liability in case of the same scenario (from Financial Year 2023-24)
| Long Short-Term Capital Gain (STCG) | (18,00,000-10,00,000) | 8,00,000 | |
| Tax on STCG (Assuming the applicable tax rate is 30%) | 30% of 8,00,000 | 2,40,000 | |
| Incremental Tax Liability | (240,000 – 95,833) | 1,44,167 |
Comparison between Fixed Deposits, Debt MF (Specified), and Equity MF
| Fixed Deposits/ Bonds | Equity Mutual Funds (Equity Exposure >65%) | Debt Mutual Funds (35%<Equity Exposure <65%) | Specified Debt Mutual Funds (Equity Exposure < 35%) | |
| Nature of Income | Interest Income | Capital Appreciation | Capital Appreciation | Capital Appreciation |
| Income tax rate | Slab Rate | STCG – 15% LTCG – 10% (exceeding 1 Lac) |
STCG – Slab Rate LTCG – 20% with indexation |
STCG – Slab Rate LTCG – No such concept (Deemed STCG) |
| Indexed Cost Benefit | NA | NA | Available | NA |
| Taxability | On Annual Basis (on interest accrued) | At the time of redemption of units (thus, allowing the postponement of tax liability) | At the time of redemption of units (thus, allowing the postponement of tax liability) | At the time of redemption of units (thus, allowing the postponement of tax liability) |
| Set off and Carry Forward of Losses | Not Available | Allowed | Allowed | Allowed |
With the tax arbitrage between debt funds (capital gains) on one hand, and bonds and FDs (interest income) on the other, gone, the FDR/Bonds/Debt MF (Specified) are now at par from a taxation perspective.
So, though it is still appealing to use debt funds to keep postponing the tax liability to your golden years when the income is relatively low, it must be noted that the gains will still get taxed as per the slab rate.
Conclusion:
In conclusion, the proposed changes seem to bring taxation of specified debt mutual funds on par with bank deposits, providing the government to tighten the arbitrage being used by HNIs to reduce their tax outgo. These changes have increased the tax liability of the investors, reducing the attractiveness of debt mutual funds as an investment option. It is imperative for investors to have a sound understanding of the tax implications of investing in debt mutual funds to make informed investment decisions.
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Disclaimer: The above compilation is for guidance and educational purpose only.
Author – CA Mridul Gupta, MRIDUL GUPTA & CO, Chartered Accountants in Practice from Delhi and can be contacted at office@camridul.in).
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