Indexation benefit on LTCG gone, should you still stay with debt MFs?

The benefit of indexation for calculation of LTCG on debt mutual funds will not be available for investments made on or after April 1, 2023

The changes proposed by the government will be applicable on debt-oriented mutual fund schemes that invest a minimum of 65% of their corpus in debt securities, and only up to 35% in equities. (File photo)

The government has proposed changes in the taxation of debt mutual funds, according to which the benefits of indexation for calculation of long-term capital gains (LTCG) on these funds will stand withdrawn for investments made on or after April 1, 2023.

The changes will be applicable on debt-oriented mutual fund schemes that invest a minimum of 65% of their corpus in debt securities, and only up to 35% in equities. These funds will no longer have a tax arbitrage over bank fixed deposits, where the interest income is taxed at the marginal tax rate of the individual.

How have debt mutual funds been taxed until FY2022-23?

Until March 31, 2023, income tax laws allow taxation of these debt mutual fund schemes on the basis of a holding period.

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If the debt mutual fund scheme unit is redeemed on or before the completion of 36 months (3 years), then the gains on the units are called short-term capital gains. Short-term capital gains are taxed at tax rates applicable to the individual’s income.

However, if the holding period exceeds 36 months, the gains are called long-term capital gains (LTCG). Long-term capital gains are taxed at 20% with an indexation benefit.

Indexation means adjusting the cost of funds after taking into account inflation in the redemption cost. It helps to calculate the new value of investment after considering inflation over the same period.

What does the amendment propose?

“It is proposed to tax the income from debt mutual funds at an applicable rate since it is of the nature of interest income,” the Finance Ministry said in a note.

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Accordingly, the benefit of indexation for calculation of LTCG on debt mutual funds will not be available for investments made on or after April 1, 2023 — in those debt mutual fund schemes where less than 35% of the total proceeds is invested in equity shares of domestic companies.

These investments will now be taxed at income tax rates applicable to your income slab. This will bring investments in debt mutual funds at par with investments in bank fixed deposits.

Many feel that the removal of tax arbitrage and the creation of a consistent tax policy across all debt instruments is good news for banks looking to attract customers with higher interest rates, and to increase their borrowing and savings book sizes.

What will be the impact on investors?

Suppose you had invested Rs 2 lakh in a debt mutual fund (investing less than 35% in equities) in March 2018 and, after five years in March 2023, the value of the investment has grown to Rs 3 lakh. As per the current regime, the benefit of indexation will be applied — and your capital gains will not be Rs 1 lakh, but will be adjusted for inflation over five years.

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So, if the cost of index inflation rises from 100 to 125 in this period, the cost of acquisition will be treated as Rs 2.5 lakh instead of Rs 2 lakh (Rs 2 lakh x 125/100) — and your capital gains would amount to only Rs 50,000 (Rs 3 lakh minus Rs 2.5 lakh). And you will be required to pay 20% tax on Rs 50,000, which is Rs 10,000.

Now, after the indexation benefit is withdrawn from April 1, 2023, if you make a similar gain over the next five years, you will have to pay tax at the marginal tax rate. The tax will be calculated on gains of Rs 1 lakh (Rs 3 lakh minus Rs 2 lakh). And if you are in the 30% tax bracket (31.2% including cess), you will be required to pay a tax of 31,200.

How will debt mutual funds be impacted?

Industry experts feel they will be dented. Niranjan Avasthi, head, product and marketing at Edelweiss AMC, said the removal of the indexation benefit from debt mutual funds is a major loss for bond markets that are still struggling with liquidity. Mutual funds are the only large active institutional investors that bring liquidity in the bond market.

Manish P Hingar, founder of Fintoo, a financial advisory firm, said this could result in investors seeking out other options. It may have a negative impact on all debt funds, particularly in the retail category, as ultra-high net worth and high net worth individuals may choose to invest in safe havens like bank fixed deposits.

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So does this make FDs more attractive?

Not necessarily. Some experts said debt funds will still hold an advantage over FDs because of their active fund management and capital gains on account of trading in the bond market. While conservative investors may be more comfortable with a bank FD as deposits of up to Rs 5 lakh are insured, savvier investors may opt for debt mutual funds. Debt mutual funds may also carry some risk on account of the riskiness of the bond papers they subscribe to.

How have AMCs stocks reacted?

The proposed changes saw an immediate impact on the share prices of mutual funds. While the share price of HDFC AMC fell 4.21% on Friday, the share price of UTI AMC and Aditya Birla Sun Life AMC were down by 4.77% and 4.44% respectively.