Recent changes in taxation rules for Debt Mutual Funds declared by the Government, has been a topic of discussion for the past few days. Several amendments were being made to the rules and regulations regarding it. In this blog, let’s explore the amendments made in the taxation regarding the specified Debt Mutual Funds and their impact on overall investments.
Let’s first understand what debt Mutual Funds are.
Debt Mutual Funds:
Debt Mutual Funds are those Mutual Funds that primarily invest in fixed-income securities such as debentures, corporate & Government bonds, and other debt instruments like treasury bills etc. Investors earn money through Debt Mutual Funds in the form of interest payments and capital appreciation. It is an attractive investment option for conservative investors who are risk averse.
Existing Taxation Rules for Debt Mutual Funds:
As of now existing calculations of taxation of Debt Mutual Funds are based on the period of holding.
Short Term: If the investment in a debt mutual fund scheme is redeemed on or before the completion of 36 months (three years), then the profits on that investment is considered as short-term capital gains (STCG).
This profit from short-term capital gains is added back to your total annual income and will be taxed at tax rates applicable to your income.
Long Term: On the contrary, if the investment is redeemed after 36 months, then profits earned are considered as long-term capital gains (LTCG).
Now, for LTCG, the benefit of indexation was applicable till now. And after indexation, the tax rate for LTCG was 20%.
In simple words indexation means adjusting (increasing) purchase price with inflation. As your purchase price would increase, your profit and taxes would be lesser.
What has changed in Debt Mutual Funds?
As per the recent amendment in Specified Mutual Funds (‘SMF’) in Finance Bill 2023, there would be “No Indexation Benefit” for the calculation of long-term capital gains on Specified debt mutual funds. SMF is debt mutual funds wherein the equity allocation of the mutual fund scheme is less than 35%. Apart from SMF, there will not be indexation benefits in the case of LTCG on gold mutual funds, international equity mutual funds, fund of funds, and hybrid mutual funds as well.
This change is applicable w.e.f. 01.04.2023. That means, if you have made the investment till 31.03.2023, you are eligible to get the indexation benefit.
From 1st April 2023, Long Term Capital Gain would be taxed as per applicable income tax rates to your income slab similar to Short Term Capital Gain.
In other words, the tax amount on interest earned on Bank Deposits & Debt Mutual Funds would be the same.
Let’s understand the calculation with an example.
For instance, Mr. Kapoor has invested Rs. 10,00,000 in F.Y. 2013-14 and sold those investments after 3 years of holding period in F.Y. 2022-23 for Rs. 20,00,000. In this transaction, he has earned a capital appreciation of Rs. 10,00,000.
CII for F.Y.2013-14 is 220 & CII for F.Y.2022-23 is 331. (CII: Cost Inflation Index)
| With Indexation Tax
(Till 31.03.2023) |
Without Indexation Tax
(w.e.f. 01.04.2023) |
|
| Date of Purchase
(F.Y.2013-14) |
01.06.2013 | 01.06.2013 |
| No. of Units | 4000 | 4000 |
| NAV at the time of Purchase | 250 | 250 |
| Total Purchase Cost | Rs. 10,00,000/- | Rs. 10,00,000/- |
| Date of Sale
(F.Y.2022-23) |
01.11.2022 | 01.11.2022 |
| NAV at the time of Sale | 500 | 500 |
| Total Selling Price | Rs. 20,00,000/- | Rs. 20,00,000/- |
| Total Profit | Rs. 10,00,000/- | Rs. 10,00,000/- |
| Indexed Cost of Purchase
(10 Lakhs*331/220) |
Rs. 15,04,545/- | N.A. |
| Total Profit after Indexation | Rs. 4,95,454/-
(Rs. 20,00,000 (-) Rs. 15,04,545) |
Rs. 10,00,000/- |
| Tax Rate | 20% | *As per income tax slab
(30%) |
| Tax Amount | Rs. 99,090/- | Rs. 3,00,000/- |
*As per income would be at least Rs. 10 Lakhs, assuming 30% tax bracket, tax liability would be Rs. 3 Lakhs.
In a nutshell, there are three categories created in Mutual Funds for taxation.
- Equity Mutual Fund Schemes that have a minimum 65% equity in portfolio: Taxation of Equity would be applicable.
- Mutual Funds Schemes having not more than 35% equity to be taxed as short-term capital gains.
- Mutual funds Schemes having more than 35% but less than 65% equity, these are still eligible for indexation and to be taxed at 20%.
Now, let’s compare the same with other debt & equity category products,
| Equity MF | Debt/Hybrid MF | Debt MF (SMF) – | Bank FD | |
| Equity: More than 65% | Equity: 35% to 65% | Equity: 0% to 35% | Equity: 0% | |
| Tax Rate | STCG: 15% | STCG: As per Slab Rate | STCG: As per Slab Rate | As per your existing slab rate |
| LTCG: 10% (Exceeding Rs. 1 Lakh) | LTCG: 20% with indexation | LTCG: No concept available (STCG) | ||
| Holding Period: 1 Year | Holding Period: 3 Years | |||
| Examples | All pure Equity Funds | Balanced Hybrid MF wherein Equity is around 35% to 65% | All pure Debt Funds | |
| Equity Savings Funds | Fund of Funds | |||
| Arbitrage Funds | Gold ETF | |||
| Aggressive Hybrid Funds | International Fund of Funds | |||
| Conservative Hybrid MF |
Note: Dynamic Asset Allocation Funds, Multi-Asset Funds & Balanced Funds will be taxed as per the Equity Exposure decision made by the Fund Manager.
Hence, with this new amendment, tax liability of debt funds (specified), and bonds and Bank FDs (interest income) are now at par from a taxation angle.
However, there is still one difference. In any Mutual Fund the gains are taxed only when the profit is booked. Hence, if the investors do not sell/redeem the MF units, the tax liability can be postponed. On the contrary, the Bank FDs the tax is charged on interest accrual basis. The interest accrued is added back to your income annually even if the FD is not matured/premature withdrawal.
What should Retail Investors do?
Making a decision just on the basis of taxation is not advisable. Being a retail investor, it is very important to diversify the investment in Equity, Debt, Gold, Real estate etc.
Going forward, investors can still go with Balanced Hybrid MF wherein Equity exposure is around 35% to 65% instead of pure Debt Funds. This category is less risky than pure Equity funds and investors can get the benefits of indexation.
Apart from Balanced Hybrid MF, investors can consider below categories as well,
- Equity Savings Fund
- Arbitrage Funds
- Multi-Asset Funds (wherein Equity Taxation is applicable)
These categories are less risky than pure Equity funds as well, offer returns somewhat similar to Debt Funds but are taxed as Equity category.
Further, investors who are in a lower tax bracket will not witness much difference in the tax treatment of debt mutual funds and Bank FDs.
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