What's the impact of new debt fund taxation?

The Central government in its recent budget amendment has changed the way the tax is treated on debt investments. Initially the budget proposal was to disallow any long-term taxation benefit for the Equity/Market-Linked Debentures (MLD). The latest amendment has extended the taxation tweak to entire debt mutual funds. The latest proposal however will impact the investors in debt funds from April 1, 2023.

According to the amendment, debt funds with less than or equal to 35 per cent invested in equity shares and/or related instruments will be taxed at the investor's income tax slab. This change has impacted all the debt funds, gold funds, international funds (which are treated as debt funds) and Fund-of-Funds. The tax arbitrage that debt funds enjoyed against the traditional debt instruments like bank fixed deposits has been wiped out.

The interest from bank fixed deposits is considered as income and is taxed accordingly. But the returns from mutual funds are treated as capital gains and the capital gain taxation would come into effect. Currently, the returns on the debt funds are treated as short-term capital gains and long-term capital gains depending upon the time frame invested. Any investments in debt for three years and over are considered as long-term capital gains and these are taxed at 10 per cent of the gains excluding indexation or 20 per cent including indexation.

Indexation is a process in which an investor can discount for inflation in the gains made investing in debt funds to counter the tax outlay. The mechanism uses the cost of inflation index (CII) which adjusts the purchase price of an asset for inflation in the year of sale. Thus, the taxes are post inflation adjustment into the gains, so the overall taxation comes down. This is particularly useful in a current high-inflation environment.

The government has been rationalising taxation across the avenues and this has been a medium-term exercise trimming at each of them in a gradual manner. A few years back, the long-term capital gains on debt funds was increased from one year to three years and now the entire long-term treatment is removed. Similar changes are being done in other investment options like Unit Linked Insurance Plans (ULIP) of life insurance where from last year there's a restriction on the tax benefits.

And coming financial year, the sec 10(10(D)) of the income tax has been amended on life insurance maturity and survival benefits where the aggregate premium exceeds Rs. 5Lakh in a financial year. Of course, a few years back, the introduction of long-term capital gains taxation for equity instruments happened. Now, with the indexation benefit removed, the taxation is at par with that the short-term, which is at the level of individual tax slabs.

For those already invested in debt or debt-oriented MF have nothing to lose as the changes being done are not retrospective. For fresh investments into this category, however, should be aware that this additional advantage on tax is not any more available. The window is small for those who wanted to grab this opportunity, the next four days to invest and get the tax advantage. Ideally, a threshold like that of insurance premium per pan would have made it easier for the retail investors. But the intention behind this rule could be to arrest the falling deposits in the banking system of the last few years. As the credit cycle begun to see an uptick in the last few quarters, the government's move could be to counter the imbalance before it turns into an alarming situation.

(The author is a co-founder of "Wealocity", and could be reached at knk@wealocity.com)