Debt Mutual Funds Taxation [2023] – LTCG and Indexation Benefits Removed

Debt Mutual Fund Taxation - image

The purpose of this article is to highlight the impact of new tax rules applicable to debt mutual funds. Debt Mutual Funds Taxation is an important aspect of investing in these schemes. Investors need to be aware of the tax implications of their investments in debt mutual funds. It is especially true in light of the recent changes in tax laws (2023-24). Understanding the taxation rules can help investors make informed decisions.

Introduction

The Lok Sabha passed an amendment to the Finance Bill 2023 on March. It aims to equalize the tax treatment of debt mutual funds with the bank’s fixed deposits. Experts say that it is good news for the bank’s fixed deposits and negative for the bond market (pure debt instruments).

Broadly speaking, there are two types of mutual funds, equity funds, and debt funds. Debt mutual funds invest in fixed-return instruments such as government bonds or corporate bonds. On the other hand, equity mutual funds primarily invest in company shares.

Debt funds bought on or after 01-Apr’2023 will be taxed as per the new rules. Debt fund units purchased before this date will be taxed as per the prevoius taxation rules.

How Debt Funds Were Taxed Before

Previously, if an investor held a debt fund units for more than three years, they would get the benefit of LTCG (long-term capital gains) tax. As per this rule, the booked profits will be taxed at a rate of 20% with indexation benefits.

Indexation benefit allows investors to inflate the purchase price of the units of their mutual funds. The investor can inflate their purchase price at the rate of inflation for the given period. The CII (Cost of Inflation Index) multiple is used to inflate the purchase price. An increase in purchase price reduces the quantum of the booked profit. Hence, the person pays a lower capital gain tax. The indexation benefit is especially beneficial in a country like India which has a high rate of inflation.

Debt funds enjoying the benefit of LTCG after indexation displayed a big tax disparity between how bank FDs are taxed and how gains on debt funds were taxed.

The Problem With The Old Tax Regime

Debt mutual funds are one form of debt instrument. Its other form is Bank’s fixed deposits.

The disparity was, the tax treatment of fixed deposits was not at par with the debt mutual funds. Gains from bank deposits, such as fixed deposits, are taxed at the investor’s income tax slab rate. There are no LTCG or indexation benefits on banks’ FDs.

Suppose a person falls into a tax slab of 30%. If he liquidates his bank’s FD, the profit from the proceedings will be taxed at a rate of 30%. But if he buy’s a debt mutual fund, his tax liability after indexation could be as low as 8% (in a five-year horizon).

This disparity gave an unfair advantage to the debt mutual funds over fixed deposits.

Just for hypothesis, consider that there is a mutual fund whose portfolio consists of only banks’ FDs. Considering the above-explained tax scenario, where the investors should invest? It will be better for investors to buy the mutual fund unit instead of buying the FDs directly, right? This way the banks will lose potential customers.

To remove the disparity, and bring debt funds at par with FDs, the government brought an amendment to the Finance Bill.

New Debt Mutual Funds Taxation (April 2023)

Debt Mutual Fund Taxation (2023-2024)

As per the amendment made to the Finance Bill, all gains generated from debt mutual funds will now be subject to short-term capital gains (STCG) tax. The STCG tax is calculated in the same manner as the tax on bank deposits.

This means that individuals falling under the 30% income tax bracket will now be required to pay the same tax rate on their debt mutual fund earnings as they would on their bank deposits.

But this new tax law is applicable only to those mutual fund schemes whose equity weight is less than 35%. Moreover, those investors who had bought debt funds prior to 01-Apr-2023 would continue to enjoy the old LTCG rule with indexation benefits. The new taxation system is applicable only on investments made on or after 01-Apr’2023.

The Ministry of Finance confirmed that this change was brought to remove the existing tax disparity between long-term investments in debt mutual funds and bank deposits.

What type of investors are most affected?

Let’s classify the investors based on their tax slabs as proposed in the new tax regime (2023-24).

The tax slabs are like this:

  • Rs 0 to Rs 3 lakh – 0%
  • Rs 3 lakh to 6 lakh – 5%
  • Rs 6 lakh to 9 lakh – 10%
  • Rs 9 lakh to Rs 12 lakh – 15%
  • Rs 12 lakh to Rs 15 lakh – 20%
  • Above Rs 15 lakh – 30%

Moreover, under section 87A, a resident individual whose taxable income is up to Rs 5,00,000 will receive a Rs 12,500 tax relief. A resident individual with taxable income up to Rs 7,00,000 will receive a Rs 25,000 tax relief.

Let’s see how people in each tax slabs will pay the tax under the old vs new taxation rules of debt mutual funds.

Tax SlabPrevious Tax LawNew Tax on Debt Mutual Funds
Up to Rs. 3 lakhNo taxNo tax
Rs. 3 lakh to Rs. 5 lakh20% with indexationTaxed at a marginal tax rate
Rs. 5 lakh to Rs. 7.5 lakh20% with indexationTaxed at a marginal tax rate
Rs. 7.5 lakh to Rs. 10 lakh20% with indexationTaxed at a marginal tax rate
Rs. 10 lakh to Rs. 12.5 lakh20% with indexationTaxed at a marginal tax rate
Rs. 12.5 lakh to Rs. 15 lakh20% with indexationTaxed at a marginal tax rate
Above Rs. 15 lakh20% with indexationTaxed at a marginal tax rate

Example

Assuming an investment of Rs. 1,00,000 in a pure debt-based mutual fund held for 5 years with a CAGR return of 10% per annum. The LTCG gains for different tax slabs under the new tax rules vs the previous tax rules are as follows:

Tax slabPrevious tax law (20% with indexation)New tax law (at marginal tax rate)
Up to Rs. 2.5 lakh00
Rs. 2.5-3 lakhRs. 294Rs. 250
Rs. 3-5 lakhRs. 5,377Rs. 2,000
Rs. 5-7.5 lakhRs. 5,377Rs. 5,050
Rs. 7.5-10 lakhRs. 5,377Rs. 8,250
Rs. 10-12.5 lakhRs. 5,377Rs. 11,050
Rs. 12.5-15 lakhRs. 5,377Rs. 13,250
Above Rs. 15 lakhRs. 5,377Rs. 16,350

Conclusion

Under the new tax law for debt mutual funds, investors who fall under the higher tax slabs (i.e., Rs. 6 lakhs to Rs. 15 lakhs and above Rs. 15 lakhs) may have to pay more tax on their gains from debt mutual funds.

This is because the LTCG tax rate under the previous tax law was 20% with an indexation benefit. Whereas under the new tax law, pure debt mutual funds will attract only short-term capital gains (STCG).

Investors in the lower tax slabs (i.e., up to Rs. 3 lakhs to Rs. 5 lakhs and Rs. 5 lakhs to Rs. 7 lakhs) may not be significantly affected by the new tax law for debt mutual funds.

Generally speaking, investors in the tax slab of Rs. 7 lakhs to Rs. 10 lakhs and Rs. 10 lakhs to Rs. 12.5 lakhs may see a slightly higher tax liability. Under the new tax law, they will pay higher taxes compared to the previous tax law. Though the tax calculation will change depending on their holding period.

Now, the investors in the higher tax slabs will prefer the bank’s fixed deposits over the debt funds. Why? For the same tax treatment, people would prefer the safer investment alternative. Bank FDs are considered more secure investments than debt mutual funds.

I think, with the new taxation rules applicable on the purchase of new debt mutual funds, more investment will now flow towards hybrid funds having equity component above 35%.

Have a happy investing.

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MANI

MANI

Hi. I’m Mani, I’m an Engineering graduate who in pursuit of financial independence, has converted into a full time blogger. After working in the corporate world for almost 16+ years, I bid it adieu....read more

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