From April 1, 2023, the indexation benefits on long-term capital gains (LTCG) on debt mutual funds will be gone. Debt mutual funds from April 1 will be taxed at income tax rates as per an individual’s income. According to experts, without indexation benefits, debt MF investments would now be at par with banking and other fixed-income products. The changes in taxation have been proposed by the government in the Finance Bill 2023 which was passed in the Parliament on Monday amid continuous uproar by Opposition leaders. As per the proposed changes, the tax advantage on debt mutual funds for investments made on or after April 1, 2023 will no longer be available. "With no indexation benefits, for long-term (>36m) holding, debt MF investments would now be at parity with banking and other fixed income products," said Lakshmi Iyer, CEO - Investment & Strategy at Kotak Investment Advisors Limited. Indexation means adjusting the cost of funds by taking inflation into account. Indexation was applied to debt fund investors with an investment horizon of more than three years. Without indexation, investors are taxed at 10 per cent. Meanwhile, long-term capital gains (LTCG) for debt mutual funds are taxed at 20 per cent with indexation benefits. "If the tax arbitrage is done away with, we will see more retail money flowing away from mutual funds back into deposits, to the detriment of their long-term goals," FinEdge Chief Operating Officer (COO) Mayank Bhatnagar said. However, only those debt MFs will lose indexation benefits where equity investment in such schemes is less than 35 per cent. This means all gains from debt mutual funds, which have less than 35 per cent exposure to equity, would be treated as short-term capital gains and taxed as per the investor’s income tax slab level. According to Nilesh Shah, Managing Director at Kotak Mahindra Asset Management Company, withdrawal of LTCG benefits for debt MF "is a push towards level playing field among Financial Services and New Tax Regime." "Debt MFs will continue to serve investors with unique benefits like diversification with as minimum amount as Rs 500, professional management, lowest cost, complete transparency and any time liquidity," Shah said. He added, "I hope that this journey reaches its logical conclusion. For example, Zero Coupon Listed Debentures continue to convert interest income taxable at 39 per cent for HNIs [high net worth individuals] to LTCG at 10 per cent." As of December 2023, institutional investors accounted for 70 per cent of investments in debt mutual funds. Meanwhile, individual investors, especially HNIs, accounted for 27 per cent of investments in such funds, a Crisil report released on Friday showed. "We hope that the government will permit debt MFs to serve investors with innovation like Cheque writing facility on Money Market Funds. This innovation will not only provide better returns to retail investors but also deepen our bond market,” Nilesh Shah said. Iyer added, "We could see some beeline to make investments pre-March 31, post which there could be multiple options which investors may evaluate before investment." She added that with the proposed changes to taxation rules, "the non-institutional participation in direct bonds (gsec and non gsec) could see some boost." "A vibrant debt market is a critical enabler of the financialisation of the retail investor base in India, and the enhanced tax efficiency of debt funds certainly serves as a hook for moving investors away from FDs into potentially higher yielding investments," Bhatnagar said. "If the tax arbitrage is done away with, we will see more retail money flowing away from mutual funds back into deposits, to the detriment of their long-term goals. Retired people who have debt-heavy portfolios and who rely on SWPs [systematic withdrawal plan] from debt funds for their incomes would be negatively impacted," he pointed out. Bhatnagar added, "We were on the cusp of a potential resurgence in the fixed income category with the launch of TMFs and several potentially high-yielding FMPs [fixed maturity plan], and this move will nip that in the bud."
