Huge tax shock for Debt fund investors

The finance bill has been passed today with amendments. While most parts of the finance bill is already part of the Hon. Finance minister’s budget speech, there is a big change to the taxation of debt mutual funds which has come as a boulder from the blue! Debt funds will be taxed as per your tax bracket irrespective of the holding period. Earlier, debt funds enjoyed the indexation benefit when held for over 3 years. This benefit is now taken away from 1st April 2023. As of now, I believe this tax change is applied to new investments after 1st April 2023 and current investments as well as new investments done by 31st Mar 2023 will still enjoy indexation benefit.

What was proposed in Hon. Finance Minister’s Budget Speech?

The Budget speech had already mentioned that Market Linked Securities (MLD) would be taxed as per investor tax bracket from 1st April 2023 under a new section 50AA. MLDs are listed securities which are purchased and sold in the market and hence were earlier taxed similar to stocks with 10% tax for Long term capital gains (LTCG) if held for over 1 year. These are typical HNI (High net worth Individuals) instrument (10 Lakhs face value) and were a hit among HNIs due to the favourable taxation and debt-like returns. 

What is added in the amendments?

The debt mutual funds which invest less than 35% assets in equity have been added to the purview of section 50AA. All debt funds currently have 0% allocation to equity and hence automatically fall under section 50AA and lose the indexation benefit from 1st April 2023.

What is the taxation for debt funds?

Debt funds will be taxed as per your slab. There will no longer be any indexation benefit for debt funds if you invest on or after 1st April 2023. This means Fixed deposits and debt funds now have similar tax structure. The justification from the Finance ministry is that all interest bearing instruments are taxed similarly. The current debt funds taxation has indexation benefit if held for over 3 years. Let us understand this with an example. Let us say you made an investment in a debt funds 3 years before and redeemed it today. The returns for a money market fund in the last 3 years was 5.74%. A Rs.1,000 investment 3 years before would have grown to Rs. 1,182 with a gain of Rs. 182. A look at the indexation table shows the indexation number to be 289 3 years before and 331 for current year. This means the indexed cost of purchase is Rs. 1,000 * 331 / 289 =  Rs. 1,145. Using this indexed cost price, the indexed capital gain is Rs. 1,182 – Rs. 1,145 = Rs. 37. The tax payable is at a flat rate of 20% (irrespective of your tax bracket). So tax payable is Rs. 7.40. This is only 4% of the full gain of Rs. 182.

What is the alternative to debt funds?

Arbitrage funds will continue to be taxed as equity oriented fund as they invest 65% or more in equity and hedge the equity risk with negative positions in futures market. They are likely to become the investments of choice for debt fund investors. The returns comparison between arbitrage funds and short maturity debt funds shows similar patterns. This means arbitrage funds can be considered as an alternative to debt funds.

What is the way forward for debt funds?

One main reason for debt fund recommendations was the favourable taxation with indexation when held for over 3 years. Now debt funds have lost this significant advantage over fixed deposits. After 1st April 2023, debt funds may not receive significant inflows from investors. I believe asset management companies are likely to change the holding for debt funds. They may add 35% investments in equity and hedge it with negative position in futures similar to arbitrage funds. This change is less than desirable but is much better than paying higher taxes. With this change, debt funds can continue with the indexation benefit. We will wait and watch for these changes

What is the impact to Gold funds and International funds?

Gold funds and international funds will also lose the indexation benefit after 1st April 2023. Asset management companies may change the underlying assets to 35% arbitrage holdings to continue the indexation benefits. We need to wait and watch for these developments. 

What is the tax impacts for Sovereign Gold Bonds (SGB)?

SGB is likely to continue to enjoy capital gains exempt status if held to maturity, though we need clarity on this. Early redemption or sale in the market will result in the capital gains taxed as per the investor tax bracket.

Debt funds still score over Fixed deposits with the following aspects 

#1 Postpone taxation 

Debt funds will be taxed on redemption. If you invest now and redeem after 10 years, you have postponed taxes for 10 years. And you would only redeem the required amount every year. Possibly the redemption amount is not taxed at 30% and instead some portion is tax free and some portion is taxed at 5%, 10% and so on. On the other hand, Fixed deposit interest is taxed every year. Even for cumulative fixed deposits, the accrued interest is taxed every year. It is likely that you are currently paying taxes at a higher bracket.

#2 Liquidity 

Debt funds are open ended funds. This means you can redeem any number of units on any day. Of course the returns are subject to interest risk and credit risk. Debt funds will remain the instrument of choice for re-balancing your asset allocation. On the other hand, Fixed deposit foreclosure has its own set of rules and there is a certain penalty applied to the interest paid for premature closure.

#3 Current debt investments still enjoy indexation benefit 

As the Finance Bill has mentioned the data of implementation as 1st April 2023, your exiting debt investments are not impacted by this change of taxation. In fact you have a few days to invest in debt funds and get indexation benefit with debt funds.

#4 Debt returns 

In a rising interest rate scenario, short maturity debt funds will give higher returns without any action from investor. On the other hand for a fixed deposit, investor needs to either wait for maturity and reinvest at a higher interest rate or fore-close the deposit by incurring fore-closure penalty and reinvest in a deposit giving current FD interest rates. However when Interest rates start moving down, the short maturity debt funds will give you lower returns. On the other hand, fixed deposits are insulated from interest rate decreases till maturity. However, at maturity it faces re-investment risk at lower interest rates.

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