Long Term Tax benefits removed from Debt Mutual Funds & its consequences

You must have heard about the Finance bill, 2023, which was passed in the Lok Sabha with 64 amendments yesterday. There are some extremely intriguing and crucial amendments have been made, one of which is relating to Debt Mutual Funds.

Let’s now go over into greater detail regarding this amendment and its consequential impact along with some key points to remember.

A. Introduction:

The first question is why the government will make such significant amendments to finance bill so many months after a budget and especially, so abruptly when no one was anticipating anything. We usually discuss the amendment relating to direct taxes on the day of the budget i.e. on 1^st February. We rarely discuss this on the day the finance bill is passed. So, it does come as a shock when something so significant comes all of a sudden that impacts the entire capital market.

As per AMFI report of February 2023, Mutual Fund is a 40.69 trillion industry and out of that approximately 19.82 trillion i.e. 48.7% is Debt funds. Therefore, you generally expect the proposal should be discussed before being passed directly in the parliament. It is also important to prepare the industry in advance that such changes are being proposed in order to minimize the negative impact on the market.

B. Proposed Amendment:

It has been proposed that investments in mutual funds on or after 01/04/2023 where not more than 35% is invested in equity shares of an domestic companies (i.e. debt funds, international funds and gold funds) will now be deemed to be short term capital gains like Market Linked Debentures i.e. it will be liable to be taxed as per slab rate.

So, in simple term regardless of holding period, mutual funds (with upto 35% of equity exposure to domestic companies) will be taxed as per slab with no indexation benefit. If the investor falls under the highest income tax bracket of 30%, they will have to pay 35.8% (including surcharge and cess) on their gains without any indexation benefit. Previously, if it was redeemed after 2 years of holding, it was classified as Long Term and 20% tax was levied on capital gains after indexation.

This brings the taxation treatment for debt funds on a par with any other bank fixed deposits, where the capital gains are added to the investor’s income and taxed at slab rates.

C. Does this mean that debt funds will become unattractive as taxation treatment for debt funds are on line with any other bank fixed deposits?

Here we may be exaggerating the impact. I agree that the taxation of FDs and debt funds will now be same. It’s just that Interest on FDs is taxed every year, whereas debt funds are only taxable when redeemed. Obviously it narrow downs the difference between FDs and debt funds, but many people who are smart enough and understand the benefits of debt funds will still prefer debt funds over FDs.

D. Who will be the Winner and Loser?

If you look at the debt market, you’ll notice that a lot of monies are in liquid funds (approximately 33.47% of debt market), and that part is unaffected because it was always paying the tax at slab rates. It is only those conservative funds with slightly longer durations of more than 3 years that are affected, which may be one-fourth of the kitty, and yeah, it is a hit; I am not denying to that part.

Also, because of the high taxes in debt funds than equity funds, more people will now shift their investments into Bonds, FDs and equity. However, investment in equity might be little risky for certain age profiles even while a particular age profile would always prefer debt over equity due to less risk.

So, I believe that the people who are actually going to suffer because of this amendment will be the NBFCs because they borrow from the debt market for 3 to 5 years duration. Now, it will be difficult for them to borrow funds as many people will now switch to equity or FDs based on their preference.

So, NBFCs and Debt Markets will clearly be losers, while Banks, Bond markets and Equity market will be winners.

E. Important Points to keep in mind:

1. The above amendments are applicable only to investments made on or after 01/04/2023 e. investments made on or before 31/03/2023 and sold after 3 years will still be considered as Long Term Capital Gain and will be taxable at 20% on capital gain computed after indexation. 

2. The proposed amendments covers only those funds whose investment in equity shares of domestic companies are less than or equal to 35%. So, this amendment will not be applicable to those funds whose investment in equity shares of domestic companies are more than 35%. So, it will be regarded as Long Term if redeemed after 3 years and will be eligible for indexation benefit. As a result, it can be summarized as follows.

F. Practical Difficulty for Assessees and CAs / Tax Consultants:

Usually, at the time of filing an ITR, the assessee provides capital gain report received from the broker to CAs / Tax Consultants. Since, reports have the classification of funds in debt and equity, CAs / Tax consultant calculates the tax based on classification. Now that above amendment will be in place from 1^st April, it will be difficult and tedious task for CAs / Tax consultants to identify the funds with how much equity exposure in domestic companies. The capital gain report will only classify the funds based on equity and debt and funds where investment in equity is only 35% will get covered in debt fund only. As a result, brokers must implement this amendment in their system so that reports generated from their software provides necessary bifurcation, which will be useful for assesses as well as CAs / Tax Consultants.

G. Closing Remarks:

The government’s objective with this amendment appears to be to align and simplify all numerous fixed-income investment options into a common tax structure. The changes have already been made in market-linked debentures (MLDs), insurance policies, and now finally, debt funds.

I have noticed that whenever the government attempts to simplify the tax rates, it makes them more complicated than before. Here also the government tries to align the tax rates but now it becomes more complicated as this amendment is applicable only for those funds whose equity exposure is up to 35%. So, instead of minimizing the complications, it creates more.