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Debt Mutual Funds Will Lose Tax Advantage Starting April

Finance ministry moves to correct tax arbitrage between debt funds and fixed deposits.

<div class="paragraphs"><p>Indian rupee notes and coins. (Photo:  Rupixen on Unsplash)</p></div>
Indian rupee notes and coins. (Photo: Rupixen on Unsplash)

The Indian government will now treat gains arising from multiple mutual fund categories, including debt mutual funds, as short-term capital gains via an amendment to the Finance Bill, 2023, which was passed today in Parliament. The change does away with the tax advantages enjoyed by these schemes.

The amendment was introduced to the Finance Bill in a clause that related to market-linked debentures. In the Budget 2023, Finance Minister Nirmala Sitharaman announced that gains from these investments would be taxed at the rates specified for each slab. The amendment added "specified mutual fund schemes" under the same clause. These mutual fund schemes include all those that have an equity allocation of less than 35%.

This means that all debt mutual funds, fund of funds, foreign funds, and gold funds will be covered. Gains from these schemes will be treated as short-term capital gains starting in April 2023 and taxed at the slab rate. This means an individual in the highest tax bracket will pay a tax of 30%.  

Currently, gains arising from debt mutual fund schemes are considered long-term after a period of three years and taxed at 20% with indexation benefits. This means that all gains are adjusted for inflation, which dramatically reduces the tax incidence. Investors have long been advised by financial advisors to consider debt mutual fund investments instead of fixed deposits because of this advantage.

The government is trying to address a tax arbitrage, a finance ministry official told BQ Prime on the condition of anonymity. Currently, interest income from a debt mutual fund is not distributed but instead is converted into long-term capital gains, which are taxed at 20% with indexation. In some cases, this results in an effective tax rate of less than 10%, the official said.

The Association of Mutual Funds In India has reached out to both the finance ministry and markets regulator Securities and Exchange Board of India, making representations and seeking clarifications, according to A Balasubramanian, chairman of industry body Association of Mutual Funds In India.

An argument has been made in the past, particularly by banks, in favour of equal tax treatment for all investments and to bring parity between fixed deposits and fixed income mutual fund schemes.

The idea of parity must be understood from the perspective of the type of investment, Balasubramanian told BQ Prime. "The mutual fund industry offers equity and fixed income investments with no guarantee of returns. Rather, they pass through losses and gains to unitholders. On the other hand, there is an element of certainty associated with the earnings from fixed deposits and investments in insurance products," he said.

"Therefore, even the capital gains tax made available to mutual funds, including indexation benefits, was coming from that assumption," he said.

Migration Of Funds Possible

For long, financial planners have advised investors, particularly those in the highest tax bracket, to choose fixed income mutual funds over fixed deposits because of the tax advantage. Now, with that tax advantage set to lapse starting April 1, incremental investments into long-term fixed income mutual fund schemes may decline.

"(Fixed income mutual fund schemes) still have one more ace up their sleeves, which is the capital gain or loss setoff is only available on mutual funds," said Mohit Gang, chief executive officer at Moneyfront. "I think a lot of money might move into arbitrage, equity savings, or conservative hybrid as a choice, but individuals should make these decisions not just to save tax but also to fit their asset allocation criteria."

There could also be a migration to physical assets like real estate and gold, which continue to enjoy a tax advantage in the form of inflation-adjusted post-tax returns.

Still Possible To Get Indexation Benefits

There will likely be a rush over the next week, with investors lining up to invest in fixed income mutual funds to take advantage of indexation benefits, said Gurmeet Chadha, chief investment officer, Complete Circle Consultants.

In fact, investing before the start of the new financial year with a time frame of just over three years will give an investor four years' worth of indexation.

"For someone who understands duration and is comfortable holding a debt allocation for longer periods, a long-duration bond fund is a good option to consider. But, for the average retail investor who wants more stability and a decent yield, maybe a banking PSU fund or a target maturity fund could be considered," Chadha said.