Government Moves To Tax Gains From Debt Mutual Funds As Short-Term Capital Gains

The Indian government is moving to treat gains arising from debt mutual funds as short-term capital gains via an amendment to the Finance Bill. The change, if approved, would result in the loss of significant benefits available to investors in the form of indexation on long-term capital gains.  

The bill is expected to be tabled in Parliament later today.

In Budget 2023, the government moved to treat gains from market-linked debentures as short-term capital gains. The amendment to the bill includes "specified mutual fund schemes", which include all schemes with equity contributions of less than 35%.

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.

If all gains from debt mutual fund schemes are treated as short-term, they would be taxed as per slab rate. So, individuals in the highest tax bracket would pay a tax of 30% on such gains.

"I hope the proposed change in the Finance Bill to remove LTCG with indexation status on debt funds is reviewed. Financialisation is just happening in India, and a vibrant corporate bond market needs a strong debt MF ecosystem," said Radhika Gupta, managing director and chief executive officer at Edelweiss Mutual Fund, in a tweet. "The success of a programme like Bharat Bond and target maturity funds in the last year was just the beginning of what could have been a lot of innovation in the bond category."

Most of the debt held by mutual funds is issued by the government of India. They are among the biggest buyers of this debt along with banks and insurance companies. At the end of February, mutual funds had assets under management of Rs 12.3 lakh crore in fixed income mutual funds.

What’s more, other categories of mutual funds could also face an impact. Hybrid schemes and gold funds with an equity allocation of less than 35% would also fall under the ambit of the proposed amendment.

As things stand, all investments made on or after Apr. 1 this year will be covered under the proposed amendment. While there is no explicit grandfathering clause, the reading of the proposed change suggests that investments prior to April 2023 will not be impacted.

Some believe that the inclusion of so many mutual fund categories is an unintended consequence of an attempt to correct some anomalies in tax laws.

"Another interpretation of the amendment implies a much smaller ambit of mutual fund schemes," said DP Singh, deputy managing director, SBI Mutual Fund to BQ Prime. "This is an amendment to a clause that relates to market linked debentures and mentions specified mutual fund schemes. It is possible that the government is trying to correct certain disparities and the inclusion of debt mutual fund schemes is an unintended consequence. We must wait for clarification."