1. Taxation of Debt Mutual Fund: A tale of two eras:
The Pre-April 2023 Era: An Investor’s Tax-Efficient Haven
Prior to 01.04.2023, the taxation of Debt Mutual Funds was governed by their holding period. If such funds were held for less than 36 months, the resultant gains were treated as Short Term Capital Gains (STCG) and were taxed at applicable slab rates of investor.
However, if the holding period of the Debt Mutual Funds exceeded 36 months, the resultant gains were treated as Long-Term Capital Gains (LTCG) and were taxed at a flat rate of 20% with the benefit of indexation. Indexation allowed investors to adjust the cost of acquisition for inflation, effectively reducing the taxable capital gains and, in many cases, the overall tax liability.
This tax structure made debt mutual funds a compelling alternative to traditional fixed deposits. Unlike FD interest, which is fully taxable at slab rates, LTCG on debt funds offered both lower tax rates and inflation-adjusted gains— particularly attractive to investors in higher tax brackets.
In essence, the combination of a reduced tax rate and indexation benefit made long-term debt mutual fund investments highly appealing under the pre-April 2023 regime. This offered HNI’s an effective blend of safety, reasonable returns and tax-efficient planning.
Post-Budget 2023: The End of Indexation on Debt Mutual Funds
The Finance Act 2023 brought a significant change to the taxation of debt mutual funds. It marked the end of the above favourable treatment. Any gains arising from a transfer of units of Specified Mutual Funds purchased on or after 1st April 2023 will be deemed as short-term capital gains arising from transfer of short-term capital asset irrespective of their holding period.
2. Section 50AA of the Act:
Special provision for computation of capital gains in case of Market Linked Debenture.
50AA. Notwithstanding anything contained in clause (42A) of section 2 or section 48, where the capital asset-
(a) is a unit of a Specified Mutual Fund acquired on or after the 1st day of April, 2023 or a Market Linked Debenture; or
“Deeming Gains, Not the Asset: Section 50AA Under the Lens”
(b) is an unlisted bond or an unlisted debenture which is transferred or redeemed or matures on or after the 23rd day of July, 2024, the full value of consideration received or accruing as a result of the transfer or redemption or maturity of such debenture or unit or bond as reduced by-
(i) the cost of acquisition of the debenture or unit or bond; and
(ii) the expenditure incurred wholly and exclusively in connection with such transfer or redemption or maturity,
shall be deemed to be the capital gains arising from the transfer of a short-term capital asset:
Provided that no deduction shall be allowed in computing the income chargeable under the head “Capital gains” in respect of any sum paid on account of securities transaction tax under the provisions of Chapter VIIof the Finance (No. 2) Act, 2004 (23 of 2004).
Explanation: For the purposes of this section-
(i)“Market Linked Debenture” means a security by whatever name called, which has an underlying principal component in the form of a debt security and where the returns are linked to market returns on other underlying securities or indices and include any security classified or regulated as a market linked debenture by the Securities and Exchange Board of India;
(ii) “Specified Mutual Fund” means a Mutual Fund by whatever name called, where not more than thirty five per cent of its total proceeds is invested in the equity shares of domestic companies:
Provided that the percentage of equity shareholding held in respect of the Specified Mutual Fund shall be computed with reference to the annual average of the daily closing figures.
Following clause (ii) shall be substituted for clause (ii) of Explanation to section 50AA by the Finance (No. 2) Act, 2024, w.e.f. 1-4-2026:
(ii) “Specified Mutual Fund” means:
(a) Mutual Fund by whatever name called, which invests more than sixty-five per cent of its total proceeds in debt and money market instruments; or
(b) a fund which invests sixty-five per cent or more of its total proceeds in units of a fund referred to in sub-clause (a):
“Deeming Gains, Not the Asset: Section 50AA Under the Lens”
Provided that the percentage of investment in debt and money market instruments or in units of a fund, as the case may be, in respect of the Specified Mutual Fund, shall be computed with reference to the annual average of the daily closing figures:
Provided further that for the purposes of this clause, “debt and money market instruments” shall include any securities, by whatever name called, classified or regulated as debt and money market instruments by the Securities and Exchange Board of India.
Analysis of provisions Section 50AA of the Act:
Section 50AA lays down the provisions for the computation of capital gains in cases where the capital asset in question is either Market Linked Debentures (MLD) or Specified Mutual Funds (SMFs) or Unlisted Bonds or Debentures and by virtue of ‘deeming fiction’ introduced under Section 50AA of the Act any capital gains arising from the transfer, redemption, or maturity of the aforementioned instruments shall be deemed to be capital gains arising from transfer of short-term capital asset, irrespective of the period of holding.
3. Section 50 vs Section 54E:
Similar to Section 50AA, a deeming fiction has also been created u/s 50 of the Act. Section 50 of the Act prescribes the manner in which the cost of acquisition in the case of depreciable asset may be computed for the purpose of determining the capital gains and that the income from such transfer shall be deemed to be capital gains arising from transfer of short-term capital asset.
The ‘deeming fiction’ created u/s 50 is restricted only to the mode of computation of Capital Gains as far as depreciable assets are concerned and it does not alter the character of the asset itself.
The Hon’ble Supreme Court in the case of VS Dempo Company Limited [2016] 74 taxmann.com 15 (SC) has also held that “The assessee is entitled to exemption under section 54E in respect of capital gains arising on transfer of a capital asset on which depreciation has been allowed. The deeming fiction created us 50 is merely for the purpose of computation of capital gains and cannot be extended to other provisions of the Act”
“Deeming Gains, Not the Asset: Section 50AA Under the Lens”
4. Interpretation of Deeming Fictions in Tax Law:
It is a well-settled principle of law that a legal fiction created by the Legislature must be strictly confined to the purpose for which it is enacted. It cannot be extended beyond its intended scope. This principle was upheld by the Hon’ble Supreme Court in the landmark judgement of State Bank of India v. D. Hanumantha Rao [(1998) 6 SCC 183].
In that case, the respondent, was an officer of the State Bank of India sought an extension of service after attaining 58 years under the SBI Officers Service Rules. As per the applicable provisions, such an extension was permitted only for officers who had been appointed prior to July 19, 1969.
Although the respondent had actually joined the Bank on July 1, 1972, he claimed entitlement to the extension on the ground that he was “deemed” to have been appointed with effect from October 26, 1966. This date was assigned to him solely for purpose of seniority, pay, and pension, owing to his past service as a Short Service Commissioned Officer in the Indian Army.
The Hon’ble Supreme Court held that the legal fiction deeming the respondent’s appointment to have commenced earlier was created solely for the limited purposes of determining seniority, pay, and pension. It categorically ruled that such fiction could not be extended to confer benefits relating to extension of service, which fell outside the scope of the deeming provision.
5. Section 54F: Independent Exemption provision:
Section 54F provides exemption from capital gains tax to an individual or a Hindu Undivided Family (HUF) on the transfer of any long-term capital asset, other than a residential house, if the net sale proceeds are invested in purchasing or constructing a residential house property within the prescribed time.
Where Specified Mutual Fund units are held for more than 24 months, the asset retains its character as a long-term capital asset, despite the capital gains being deemed as short-term under the fiction created by Section 50AA.
Accordingly, it may be reasonably contended that the assessee would be eligible to claim exemption under Section 54F, subject to the fulfilment of other prescribed conditions under that section. The deeming fiction under Section 50AA does not override the true nature of the asset for purposes of determining the eligibility these exemptions. Thus, one can argue that exemption under Section 54F should be available in respect of capital gains arising from the
“Deeming Gains, Not the Asset: Section 50AA Under the Lens”
transfer of Specified Mutual Funds. This is also supported by below legal precedents
Thus, High-net-worth individuals (HNIs) can optimise their tax liability by investing the capital gains arising from the redemption of Specified Mutual Funds into a residential house property, subject to the conditions laid down under Section 54F of the Income-tax Act.
Legal Precedence’s
In the landmark judgement of Ace Builders (P.) Ltd [2005] 144 Taxman 855 (Bombay), the Hon’ble Bombay High Court has held that “The assessee fulfilled all the conditions set out in section 54E to avail exemption, but the exemption was sought to be denied in view of fiction created under section 50. The assessee could not be denied exemption under section 54E, because, firstly, there is nothing in the section to suggest that the fiction created in section50 is not only restricted to sections 48 and 49 but also applies to other provisions. On the contrary, section 50makes it explicitly clear that the deemed fiction created in sub-sections (1) and (2) of section 50 is restricted only to the mode of computation of capital gains contained in sections 48 and 49 and cannot be extended beyond that. Secondly, it is well established in law that a fiction created by the Legislature has to be confined to the purpose for which it is created. Thirdly, section 54E does not make any distinction between depreciable asset and non-depreciable asset and, therefore, the exemption available to the depreciable asset under section54E cannot be denied by referring to the fiction created under section 50. Section 54E specifically provide sthat where capital gain arising on transfer of a long-term capital asset is invested or deposited (whole or any part of the net consideration) in the specified assets, the assessee shall not be charged to capital gains. Therefore, the exemption under section 54E could not be denied to the assessee on account of the fiction created in section 50”
Judicial precedents make it clear that deeming provisions should not be extended beyond their specific intent.
Other judicial precedents affirming the above view:
♦ CIT v. Assam Petroleum Industries (P.) Ltd.[2003] 131 Taxman 699 (Gau.)
♦ CIT v. Aditya Medisales Ltd. [2013] 38 taxmann.com 244/218 Taxman 477/[2014] 362 ITR 600 (Guj).
“Deeming Gains, Not the Asset: Section 50AA Under the Lens”
♦ CIT v. Cadbury India Ltd. [2015] 53 taxmann.com 227/229 Taxman 5/[2014] 90 CCH 381 (Mum.).
♦ CIT v. Polestar Industries [2014] 41 taxmann.com 237/221 Taxman 423/[2013] 86 CCH 298 (Guj.)
6. Section 74: Losses under the head Capital Gains:
Section 74 of the Income-tax Act, 1961 deals with the carry forward and set-off of capital losses. The provisions of the same are reproduced below:
74. Losses under the head “Capital Gains”
[(1) Where in respect of any assessment year, the net result of the computation under the head “Capital gains” is a loss to the assessee, the whole loss shall, subject to the other provisions of this Chapter, be carried forward to the following assessment year, and-
(a) in so far as such loss relates to a short-term capital asset, it shall be set off against income, if any, under the head “Capital gains” assessable for that assessment year in respect of any other capital asset;
(b) in so far as such loss relates to a long-term capital asset, it shall be set off against income, if any, under the head “Capital gains” assessable for that assessment year in respect of any other capital asset not being a short-term capital asset;
(c)if the loss cannot be wholly so set off, the amount of loss not so set off shall be carried forward to the following assessment year and so on.]
(2) No loss shall be carried forward under this section for more than eight assessment years immediately succeeding the assessment year for which the loss was first computed.
Accordingly, as per Section 74, the Brought forward long term capital losses can be set off only against income arising from transfer of long term capital asset.
Set-Off of Brought Forward Long-Term Capital Losses Against Gains on Specified Mutual Funds
Following the legal reasoning as discussed above, the gains arising on transfer of ‘Specified Mutual Funds’ shall be ‘deemed to be capital gains arising from transfer of short-term capital asset’ as per the fiction created u/s 50AA of the Act. However, this deeming provision is only for the limited purpose of
“Deeming Gains, Not the Asset: Section 50AA Under the Lens”
computing capital gains as mentioned in section 50AA and it does not alter the nature of the capital asset itself.
Accordingly, if the Specified Mutual Funds are held for more than 24 months, they would still qualify as long-term capital assets, even though the gains arising from their transfer are deemed as short-term. For the purpose of Section 74, the gains arising from the transfer of asset continue to be capital gain arising from transfer of long-term capital asset. As a result, we a plausible view can be taken that the brought forward long-term capital loss can be set off against the capital gains arising from the transfer of such Specified Mutual Funds.
Judicial Precedents affirming the above:
♦ Commissioner of Income-tax v.s Parrys (Eastern) (P.) Ltd. [2016] 66 taxmann.com 330 (Bombay)/[2016] 238 Taxman 14 (Bombay)/[2016] 384
♦ Komac Investments & Finance (P.) Ltd. v. ITO [2011] 132 ITD 290/13 taxmann.com. 185 (Mum.)
♦ Principal Commissioner of Income-tax v. Peerless General Finance & Investment Co. Ltd. [2023] 146 taxmann.com 285 (Calcutta)
Author: CA Samruddhi Mehta, a practicing Chartered Accountant and Partner at A M S M Associates, Chartered Accountants, Pune. Co-authored with fellow partner, CA Ankur Mehta.
CA Samruddhi Mehta |
CA Ankur Mehta |
Author Bio
