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Business News/ Money / Personal Finance/  Debt Mutual Funds Taxation Rules Amended: How Will It Affect Your Investments?

Debt Mutual Funds Taxation Rules Amended: How Will It Affect Your Investments?

Starting April 1, 2023, the Budget Bill, 2023 passed in the Lok Sabha today removes the indexation benefit and long-term capital gains tax break from debt mutual funds, exchange-traded funds (ETFs), gold funds, and international funds. This means that any gains (regardless of holding time) from these funds will be taxed at the individual's tax bracket. Debt funds still offer the advantage of deferring tax due, but investors need to be aware of the new tax rate which will apply to their gains. Individuals still have time to take advantage of the indexation benefit before it is removed on April 1, 2023, but the tax rate on the gains will still remain the same. Investors should also be on the lookout for debt funds with a 35% equity allocation to maintain the same tax benefits.

Finance Bill proposes removal of tax advantage for debt mutual funds. istock photo (MINT_PRINT)Premium
Finance Bill proposes removal of tax advantage for debt mutual funds. istock photo (MINT_PRINT)

When passing the Budget Bill, 2023 in Lok Sabha earlier this week, the central government made amendments to the taxation of debt mutual funds. Beginning April 1, 2023, any gain (regardless of the holding time) from debt funds, exchange-traded funds (ETFs), gold funds, or international funds will be taxed at the individual's tax bracket (or at the slab rate). Long-term capital gains tax breaks and indexation benefits, in other words, are no longer available.

Here's how you will be affected by this change.

What has changed for debt mutual funds?

According to the amendments made in Budget 2023, investments made on or after April 1, 2023, will not be eligible for the indexation benefit for calculating long-term capital gains on debt mutual funds. However, only those debt mutual funds where equity investments do not exceed 35% will forgo this advantage.

What is the current taxation rule?

Today, any capital gain on withdrawal of a debt fund held for three years or more is considered long-term capital gain and is taxed at a fixed 20% rate with indexation benefit. Any capital gain realized on withdrawal within three years is considered short-term capital gain and is taxable at the individual's income tax bracket.

Tax arbitrage enjoyed by debt funds over bank fixed deposits is no longer available.

Due to the fact that interest income from bonds and fixed deposits (FDs) is taxed at the individual's tax slab, debt mutual funds have historically had a significant tax advantage over bank FDs. Till today, high income tax payers paid almost no tax after accounting for the indexation benefit and a flat rate of 20%, but this is no longer the case starting April 1, 2023. As a result, if your taxable income is subject to the highest tax rate of 30%, then you will pay the same tax rate on your interest income from the bank deposits. Whereas if a debt mutual fund is liquidated after 36 months, the LTCG is taxed at 20% only and that too after the indexation benefit. Apart from a lower rate of tax, investment costs are adjusted for inflation, and debt mutual funds can see better post-tax returns.

Basically, from or after April 1, 2023, investments made in debt mutual funds (where the equity part of the mutual fund scheme does not exceed 35%) will be subject to income tax at the rates that correspond to the individual's income bracket.

Equity Investment Component0-35%35-65%>65%
STCGAs per your tax slabAs per your tax slab15% without indexation
LTCGAs per your tax slab20% with indexation after 3 years of holding period10% without indexation after 1 year holding period

How will taxes affect my mutual funds?

Note: The above rates apply to all sorts of debt funds, international funds, gold funds, international fund of funds, hybrid funds, equity funds (including equity savings, arbitrage funds, and balance advantage funds), and it depends on how much equity is in the scheme.

What should investors do now?

Individual investors who want to take advantage of the tax benefits of indexation have a limited amount of time until March 31, 2023 to invest in debt mutual funds. They should get their investment registered on or before this date to keep getting the indexation benefit until the mutual funds are liquidated.

Is there still a rationale to invest in a debt fund?

Yes, it is worth noting that the value of the debt product still remains true in other respects, such as the fact that, unlike FDs, debt funds can help you postpone your tax due. When you have the choice of offering bank interest income for taxes on a receipt or accrual accounting, most individuals choose to get taxed on an accrual basis accounting because it helps eliminate the potential of an income tax department enquiry for a data mismatch. While it may seem enticing to use debt funds to maintain deferring tax duty until your retirement life when your income is fairly modest, it should be remembered that the profits will still be taxed at the slab rate. Even with the tax changes, debt mutual funds such as liquid, or a low-duration funds remain relatively attractive compared to alternative short-term investing opportunities such as parking in a bank savings account or a short-term fixed deposit. Long-term or medium-term debt mutual funds may be impacted when compared to long-term bank deposits.

I anticipate a flood of debt funds that will have a 35% equity allocation in the form of pure equities or arbitrage funds and a balance of 65% in debt in the future. If these funds meet your risk profile, you may look out for them to continue receiving the same tax benefits. Aside from the indexation benefit, other perks should not cause you to abandon debt funds.

Rishabh Parakh is a Chartered Accountant and a founder of NRP Capitals.



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Published: 25 Mar 2023, 11:34 AM IST
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