Finance Bill proposes removal of tax advantage for debt mutual funds

Debt mutual funds, which so far enjoyed taxation benefit as long-term capital gains (LTCG) were taxed at 20% with indexation benefit, stand to lose this advantage from 1 April 2023.

The Finance Bill has proposed some amendments. One such amendment is investments in mutual funds with up to 35% equity exposure to domestic companies, essentially debt funds, are liable to be taxed as per the investors’ income tax slab rate.

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 his or her slab rates.

So, now an investor regardless of his or her holding period in a debt mutual fund (previously, LTCG was applicable after three years), will be taxed as per his/her slab. If the investor falls under highest income tax slab rate of 30%, then he or she will have to pay 35.8% (including surcharge and cess) on their gains without any indexation benefit.

Industry experts say this would not only impact investor flows into debt mutual funds, but also bond market as a whole. “Mutual funds offered liquidity in the domestic bond market, which is otherwise quite illiquid. Investor flows coming into debt MFs were deployed into the bond markets,” points out Niranjan Avasthi, head, product, marketing and digital business, Edelweiss Asset Management.

“This move not only impacts debt MFs, but also international funds and gold funds,” says Kirtan Shah, founder and CEO of Credence Wealth.

Vikram Dalal, managing director at Synergee Capital Services, says that earlier a target maturity fund, depending on the underlying portfolio, could offer post-tax yield of 7%. “There was a good tax arbitrage in such funds as FD with interest rate of 8% could offer only post-tax return of 5% for those at highest tax slabs,” he says.

Fund houses might be able to offer some alternative to still offer tax benefits by adding arbitrage (equity derivative strategies) in some hybrid funds.

For example, one investment expert said that the equity exposure can be kept at 40% in some hybrid schemes by adding 5% equity derivatives. But this would finally depend on the market regulator Securities and Exchange Board of India (Sebi) whether it allows such a product or not. Sebi has defined each fund category and the asset allocation framework for each of these fund categories.

Grandfathering

For investors that invest in a debt MF before 1 April 2023, there is still a silver lining. As the new tax treatment will be applicable from 1 April.

So, any investment done before this date will still enjoy the LTCG tax rate of 20% with indexation benefit after three years.

However, if you have systematic investment plans (SIPs) in a debt mutual fund, then note that units bought after 1 April will be subject to the new tax treatment, where capital gains arising from sell of these units are taxed at your income tax slab.