Debt Mutual Funds: No More Long-term Tax Privileges

The government has decided to remove the favourable long-term capital gains treatment, which includes indexation benefits, for income generated from debt mutual funds and other schemes investing up to 35% in domestic company equities.

The Previous System: Earlier, capital gains from the transfer of mutual fund units (excluding equity-oriented funds) held for over three years were considered long-term investments and were taxed at 20% with the benefit of indexation.

The Rationale behind the Reform:

• Under the existing system, the interest earned from debt mutual funds (where no more than 35% is invested in domestic company shares) is not distributed as income but is converted into long-term capital gains taxed at 20% (with indexation). In some cases, due to indexation, it may even be reduced to less than 10%, providing an arbitrage opportunity.
• Many taxpayers have been able to decrease their tax liability using this arbitrage. Therefore, the tax provisions that were first introduced in the 2023-24 Budget for market-linked debentures have now been expanded by the government to include debt funds.

The New System:

• The government will now consider such returns as short-term and tax them according to the slab rate.
• This proposed move will align the taxation of mutual funds and bank deposits, impacting investments made in such funds from April 1, 2023, onwards.
• While this decision might affect certain mutual fund products negatively, it will streamline the tax system.
• The primary target of this proposed reform is affluent investors and family offices that have been exploiting tax loopholes in the existing tax system.

Potential Concerns and Consequences:

• Given that these changes will also apply to gold funds, domestic fund of funds, and international funds with an equity exposure of up to 35%, some financial experts believe that this move could have widespread implications.
• As a fallout of this reform, several investors might decide to shift their investments to bank fixed deposits, equity mutual funds, hybrid funds that allocate more than 35% of their portfolios to equity, and Sovereign Gold Bonds .