Opinion Express View on Finance Bill 2023: Principles underlying tax architecture need wider debate

The Finance Bill 2023 was passed by voice vote in the Lok Sabha last week with 64 amendments. While these amendments warranted extensive debate and examination of their far-reaching consequences, no such discussion took place in the House. Among the amendments passed is the contentious decision to scrap the tax benefit for debt mutual funds. From April 1, investors in debt mutual funds cannot avail the benefit of indexation for calculation of long-term capital gains. These investments will now be taxed at income tax rates applicable to an individual’s tax slab. While this move aims to remove the advantage that such debt funds have over bank deposits, its far-reaching ramifications need to be carefully examined.

Indexation — which is offered to debt fund investors if the investment is redeemed after 36 months — means adjusting the cost of funds by taking inflation into consideration. In the case of debt funds, long-term capital gains were taxed at 20 per cent with indexation benefits. This benefit brought down an investor’s tax liability. However, there are concerns that the withdrawal of the benefit will lead to investors reassessing their allocations to debt mutual funds. This may impact flows into these funds. And as debt mutual funds in turn channel funds into the bond market, this move is being seen as one that is to the detriment of the growth and development of the bond market in India. According to a report by Crisil, 70 per cent of the investment in debt funds flows from institutional investors, while individual investors, including high net worth individuals, accounted for 27 per cent as of December 2022. Thus, to the extent that this change in rule will trigger a shift in these investments away from debt mutual funds to other instruments (debt funds account for a sizeable portion of the total assets under management of mutual funds in India), this will possibly affect flows to the corporate bond market and thus demand for corporate debt is likely to be impacted. Further, while doing away with this tax advantage, the finer points of differentiation between bank deposits and debt funds also need to be acknowledged — bank deposits are insured up to Rs 5 lakh while debt mutual funds do carry risk depending on the risk profile of the bonds they hold.

Advertisement

It has been argued that the capital gains architecture in India as it exists needs to be reexamined and reconfigured. Not only are there different rates of taxation for different asset classes, but even the holding period for differentiating between short-and long-term capital gains varies across assets. Thus rationalisation with regard to the tax rate and/or the holding period is desirable. These issues and, more broadly, the principles underlying the tax architecture in India need to be widely discussed and debated.