Know how amended taxation rules in debt mutual funds will redefine investments

New Delhi: The central government amended the taxation of debt mutual funds in the Finance Bill, 2023, which was passed by the Lok Sabha earlier this week. The Ministry of Finance announced that any gain (irrespective of how long you stay invested) from debt funds, exchange-traded funds (ETFs), gold funds, or international funds will be taxed at the individual's tax bracket beginning April 1, 2023. (or at the slab rate). This implies investors will no longer be able to avail themselves of the benefits of long-term capital gains tax breaks and indexation.

What has changed in debt mutual funds?

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, as per the Budget 2023 amendments. Only debt mutual funds with equity investments of less than 35 per cent will be exempt from this benefit.

What do the new taxation rules say?

Currently, capital gains from withdrawals from debt funds held for more than three years are recognized as long-term capital gains and are taxed with the benefit of indexing at a fixed rate of 20 per cent. Realized capital gains paid within three years are considered short-term capital gains and are taxable under the personal tax bracket. Shockingly, the tax arbitrage that debt funds enjoyed over bank fixed deposits is no longer available.

Debt funds have historically had a significant tax advantage over bank fixed deposits, as the interest income from bonds and fixed deposits are taxed at personal tax rates. So far, given the benefits of indexing and a flat rate of 20 per cent, high-income taxpayers have paid very little tax. This also explains why many risk-averse investors allocated their earnings to debt fund instruments. However, this is set to change from April 01, 2023. The new rules mandate that investors will be now subject to the highest tax rate of 30 per cent on their taxable income, thus, forcing one and all to pay the same tax rate on the interest income from the bank deposits. If the debt fund is withdrawn after 36 months, the long-term capital gain (LTCG) will only be taxed at 20 per cent, post the indexation benefit.

Putting money in debt mutual funds (where the equity portion of the mutual fund scheme does not exceed 35 per cent of the total AUM) will be subject to income tax at the rates applicable to the individual's income bracket beginning April 1, 2023.

Regarding the amendments that have been proposed in the finance bill, Sandeep Bagla, CEO, Trust Mutual Funds said, “In the last one to two years, mutual funds have seen outflows from debt schemes, despite the tax benefit. The only segment that saw inflows was the spate of target maturity funds which were passively holding G-Secs, mimicking fixed deposits but with tax benefits. Investors may be reluctant to redeem even after the completion of three years now as incremental income from these investments may remain tax efficient. Few investors may remain invested wanting to defer tax as tax is payable only at redemption. Incremental inflows will come into funds that are able to manage their portfolios actively and generate inflation-beating returns for investors. There is likely to be no impact in the short term but could impact the ability of mutual funds to attract debt flows in the long term.”

What options are available to investors now?

Individual investors looking to avail of the tax benefits of indexation must invest in bond funds by March 31, 2023. Investments must be registered by this date to continue receiving the benefits of indexing until the mutual fund is liquidated.

Should you invest in debt funds?

Now that the amended taxation rules put both debt funds and bank deposits on the same page, it is pertinent to ask if one must still put money in debt funds. Don’t forget that the value of the debt product remains true in other ways, unlike FDs, considering how the former can help you postpone your tax due date. When given the option of taxing bank interest income on a receipt or accrual basis, most people choose accrual because it eliminates the possibility of an income tax department inquiry for a data mismatch. While it may appear appealing to use debt funds to continue deferring tax duty until your retirement life when your income is relatively modest, it should be remembered that the profits will still be taxed at the slab rate.

Even after the tax changes, debt mutual funds such as liquid or low-duration funds remain much more appealing when compared to alternative short-term investing options including allocations to savings accounts or short-term fixed deposits. When compared to long-term bank deposits, long-term or medium-term debt mutual funds may be impacted.