Government Removes LTCG Tax Benefit From Debt Mutual Funds

The government on March 24, 2023 passed amendments to the Finance Bill 2023. One of the major highlights was removing the long-term capital gains (LTCG) tax benefit from debt mutual funds.

According to the amendments announced by Union Minister of Finance Nirmala Sitharaman, debt mutual funds having not more than 35 per cent invested in equity shares would be taxed at the income tax slab level. In effect, they will be treated as short-term capital gain (STCG), in much the same way as bank fixed deposits (FDs).

At present, debt mutual funds are treated as long-term investments if held for three years and taxed as long-term capital gains (LTCG) at 20 per cent with indexation benefit. If held for less than three years, they are treated as STCG and taxed in accordance with the investor’s income tax slab.
 
“At present, capital gains arising from transfer of mutual fund units, other than equity-oriented funds which are held for more than three years are considered as long term and are taxed at 20  per cent with indexation benefit. The amendment to the Finance Bill 2023 has proposed to treat gains from transfer of units of specified mutual funds as short term and tax at slab rates. This is in addition to taxation of market linked debenture proposed in the original bill,” says Tapati Ghose, partner, Deloitte India.

The changes will come into effect from April 1, 2023 onwards.

According to experts, the change could lead to people shifting to safer bank FDs because of two reasons. FDs are safer than debt mutual funds as they offer guaranteed returns unlike the later which are subject to market conditions. Second, the similar taxation of debt funds to FDs have now robbed debt funds of the taxation benefit they enjoyed over FDs.

“Pure debt fund will lose its attraction over fixed deposits as far as tax benefits are concerned. Further life insurance products would be superior to debt mutual funds for annual investments up to Rs. 5 lakh. The new regulations may impede the development of India's debt capital market to some extent in this way.  However, this amendment shall only be applicable in respect of investments made post April 1, 2023 and there shall be no impact on investment made on or before March 31, 2023,” says Vivek Jalan, partner, Tax Connect Advisory, a multi-disciplinary tax consultancy firm.

“The proposed move seems to bring taxation of such mutual funds on par with bank deposits which are taxed at slab rates. While the proposed amendment shall impact transfer of the units of specified mutual funds acquired on or after 1 April 2023 while the grand fathering benefit is not available for market linked debentures,”Ghose adds.

“One may recall that in 2014, the government had changed the taxation of debt mutual funds (period of holding for short term gains was increased to 3 years and tax rates were increased to 20 per cent,” she further says.

“I hope the proposed change in the Finance Bill to remove LTCG with indexation status on debt funds is reviewed. Financialization is just happening in India and a vibrant corporate bond market needs a strong debt MF ecosystem,” Radhika Gupta, managing director and CEO, Edelweiss Asset Management Limited said in a Tweet.

People who are closer to their retirement age could shift a major chunk of their investment corpus to FDs and other debt instruments rather than debt mutual funds, according to experts.

The amendment could also give a boost to equity mutual fund investment for the general category of mutual fund investors, as equities, though risky, offer higher returns than debt mutual funds, and they will score over debt mutual funds in matters of taxation as well after the new amendment.

Sitharaman had also made another major announcement related to market-linked debentures in Union Budget 2023. It has been proposed to tax market-linked debentures as STCG only. 

Market-linked debentures are non-convertible debentures where the return is not fixed, but depends on the performance of the underlying index.