If you invest in debt mutual funds, the recent developments in late March 2023 would have come as a shock to you, even requiring you to relook at your financial plan.
What Has Changed?
The taxation of debt mutual funds will change, starting April 1, 2023.
For the debt mutual fund investments made until March 31, 2023:
- Your holding period decides how you are taxed.
- The short-term capital gains (holding period <= 3 years) on debt mutual funds are taxed at your marginal tax rate.
- The long-term capital gains (holding period > 3 years) on debt mutual funds shall be taxed at 20% after indexation. This reduces the tax liability significantly, especially for those in the highest income tax bracket.
For the debt mutual fund investments made on or after April 1, 2023:
- There is no concept of long-term capital gains.
- Any gains on sale of a debt mutual fund, irrespective of the holding period, shall be considered short-term capital gain and be taxed accordingly. At the marginal income tax rate.
- If you have been investing in debt funds and belong to higher income tax brackets, this is a big hit to you. Your tax outgo on sale of debt funds will increase significantly.
Note: Your existing debt mutual fund investments (those made until March 31, 2023) will continue to get indexation benefit irrespective of when you sell these investments. Nothing changes for these old investments.
The new rules apply only to investments made on or after April 1, 2023.
By the Way, What Are Debt Funds?
For you and me, debt funds are mutual funds that invest in Government or Corporate bonds instead of stocks. However, the Income Tax Act does not define debt funds in such a way. In fact, it does not even speak about debt mutual funds. The Income Tax Act classifies mutual funds based on how much exposure they have to domestic stocks and prescribes taxation accordingly.
Earlier (until March 31, 2023), there were only 2 classifications.
- Equity mutual funds (Domestic equity exposure >=65%)
- Defined as “Equity oriented fund” in Section 10 (38) of the Income Tax Act
- Short term gains (holding period <= 12 months) taxed at 15%
- Long term gains (holding period > 12 months) taxed at 10%
- Other funds (Domestic equity exposure < 65%)
- Short term gains (holding period <= 3 years) taxed at marginal tax rate
- Long Term gains (holding period > 3 years) taxed at 20% after indexation
The clauses pertaining to holding period to qualify as short/long term capital gains are in Section 2. The capital gains calculation including provision for indexation is provided in Section 48 of the Income Tax Act.
See, no mention of debt funds per se. Since debt funds would have lower than 65% in domestic stocks, it would automatically fall in Bucket (2). Similar, even gold funds or international equity funds (these have stocks but not domestic stocks) will fall under (2).
From April 1, 2023, there will be 3 classifications.
- Equity mutual funds (Domestic equity exposure >=65%)
- Short term gains (holding period <= 12 months) taxed at 15%
- Long term gains (holding period > 12 months) taxed at 10%
- Classification 2: (Domestic Equity exposure >=35% and < 65%)
- Short term gains (holding period <= 3 years) taxed at marginal tax rate
- Long Term gains (holding period > 3 years) taxed at 20% after indexation
- Classification 3: (Domestic Equity exposure < 35%)
- All gains, irrespective of holding period, shall be considered short term capital gains. And taxed at marginal income tax.
- No concept of long-term capital gains.
As you can see, debt funds will fall under Bucket (3) now.
Existing Classification of Mutual Funds and Their Taxation (for Investments Made up to March 31, 2023)
| Exposure to Domestic Stocks | Less than 65% | 65% and above |
| Short-Term Holding Period | Up to 3 years | Up to 12 months |
| Long-Term Holding Period | More than 3 years | More than 12 months |
| Short-Term Capital Gains Tax | Marginal Tax Rate | 15% |
| Long-Term Capital Gains Tax | 20% after indexation | 10% |
| Fund Categories (domiciled in India) | 1. Balanced Hybrid Funds 2. Debt mutual funds/ETFs/FoFs 3. Conservative Hybrid Funds 4. Gold Mutual Funds/ETFs/FoFs 5. Foreign Equity funds/ETFs/FoFs | 1. Equity funds 2. Arbitrage Funds 3. Balanced Advantage Funds 4. Aggressive Hybrid Funds |
Classification of Mutual Funds and Their Taxation (for Investments Made on or after April 1, 2023)
| Exposure to Domestic Stocks | Less than 35% | 35%-65% | 65% and above |
| Short-Term Holding Period | Everything is short-term. No concept of long-term capital gains | Up to 3 years | Up to 12 months |
| Long-Term Holding Period | More than 3 years | More than 12 months | |
| Short-Term Capital Gains Tax | Marginal Tax Rate | Marginal Tax Rate | 15% |
| Long-Term Capital Gains Tax | Not applicable. All gain taxed as STCG | 20% after indexation | 10% |
| Fund Categories (domiciled in India) | 1. Debt mutual funds/ETFs/FoFs 2. Conservative Hybrid Funds 3. Gold Mutual Funds/ETFs/FoFs 4. Foreign Equity funds/ETFs/FoFs | 1. Balanced Hybrid Funds | 1. Equity funds 2. Arbitrage Funds 3. Balanced Advantage Funds 4. Aggressive Hybrid Funds |
What Are Your Options from April 1, 2023?
There are many interest-bearing products that investors did not find attractive compared to debt funds simply because of benign tax treatment of long-term capital gains. The interest that such products paid gets taxed at the marginal income tax rate.
Debt funds used to get indexation benefit and lower tax (20%). With this tax advantage withdrawn, those products come back into reckoning:
- Bank Fixed Deposits: At par with debt funds on the tax front now. Well almost. Debt mutual funds still have a few advantages over bank fixed deposits.
- Corporate Fixed Deposits: Be mindful of the risk. Not all corporate FDs are the same.
- Treasury bills and Government Bonds: No risk. Great product. Can even use this to lock-in interest rates for a very long time. That’s not possible with bank FDs or even debt mutual funds.
Apart from that, a few investors may find merit in non-participating traditional life insurance plans as part of the long-term fixed income portfolio. These plans have many shortcomings including high costs, low returns, and limited flexibility. If you keep annual premium under the limit of Rs 5 lacs, you can earn tax-free returns. Despite the limitations of these plans, the lure of tax-free guaranteed returns may attract certain investors.
And yes, PPF and SSY. Didn’t write about these earlier since these are much superior to debt funds for long-term allocations.
What Are the Options in Mutual Funds?
Debt funds (that funds that invest in bonds) will simply not be eligible for indexation benefits and 20% long term capital gains tax.
But there is a broader category of hybrid funds that becomes attractive now. Perhaps not in their current avatar but expect a lot of action in the hybrid funds space over the next few months. The AMCs may inch up the equity allocation (or somehow reduce risk) to make a category a more palatable replacement for a debt mutual fund.
Listing the various hybrid fund categories permitted by SEBI below:
Arbitrage funds are already there. These funds generate returns by exploiting arbitrage opportunities between cash and futures markets. The nature is such that these funds are risk and return characteristics of debt funds. However, the tax treatment is that of an equity fund (STCG at 15%, LTCG at 10%) since these funds own more than 65% stocks. The returns are similar to a liquid fund. Now, many investors may NOT like to own these funds for the long term because of lower return expectations.
What can such investors do? Either take risk or expect some support from AMCs or both.
For instance, such investors can look at “Equity savings fund”. In their current avatar, these funds may be carrying a lot more risk that a debt fund investor would like. However, the AMCs may choose to reduce risk by including more arbitrage in these funds. As I said, you will need some support from AMCs.
You must be careful. Don’t fall for the pitch that “Balanced Advantage Funds (or any other category of funds) tend to give better returns than a debt fund over a 3 to 5-year period. Hence, can be used as a replacement for a debt fund”. While I like balanced advantage funds per se, these can’t be a replacement for a debt fund. Such funds are more like less volatile equity funds.
Don’t just focus on taxation. Appreciate the risk in various fund categories before investing.
Where are you planning to invest?