Debt MFs: Will no indexation benefits make it less attractive?
Debt mutual funds are one of the best options for investors looking for safe and secure returns. The indexation benefits were another advantage of debt funds. Interest earned through bank fixed deposits is taxed per your income tax slab. However, capital gains in debt funds had indexation benefits, which made it very attractive, especially to investors who were in higher tax slabs and had a mid-term investment horizon.
Today, we will discuss the new rule that takes away the indexation benefit of debt funds.
What are debt funds?
Debt funds are fixed-income schemes that invest in debt and money market instruments like CPs, CDs, T-Bills, Corporate Bonds, G-Secs, etc. They pay interest (called a coupon) at pre-defined intervals and face value upon maturity. The yields of most instruments are usually higher than bank fixed deposit interest rates of similar maturities. Yields of AAA-rated corporate bonds can be 150 – 200 bps higher than FD interest rates. In addition to higher yields, since these instruments are traded in the market, you can benefit from price appreciation.
What is the current capital gains tax on debt funds?
The taxation of debt funds depends on your holding period. The capital gains are taxed as below:
- Short-term capital gain: If your holding of debt funds is less than 36 months (3 years), the capital gains made from the sale of debt funds fall under the category of short-term capital gains for taxation. Short-term capital gains get added to your income and taxed as per your income tax slab.
- Long-term capital gains: If your holding period is longer than 36 months (3 years), the capital gains from the sale of units are called long-term capital gains. Until now, the capital gains are taxed at 20% after allowing for indexation benefits.
Understanding indexation
Indexation in income tax for debt funds is a method used to adjust the purchase price of an asset for inflation. Let us understand indexation with an example and see how indexation benefits investors in the case of debt funds.
| With Indexation | Without Indexation | |
| Investment Value | 1,00,000 | 1,00,000 |
| Sales Value | 1,50,000 | 1,50,000 |
| Tax Applicable | LTCG | STCG |
| Capital Gains | 50,000 | 50,000 |
| Indexation Benefit | Yes | No |
| Inflation Rate (From CII) | 15% (assumption) | - |
| Indexed Value of Asset | 1,15,000 (Investment value + CII inflation rate) | - |
| Taxable Gains | 35,000 | |
| Tax Rate | 20% | As per Income Tax slab (assume 20%) |
| Tax Outgo | 7,000 | 10,000 |
| Tax Savings | 3000 |
(Note - the numbers (gains, CII, etc) are for understanding purposes only and not real)
Finance Bill 2023
Today, the government has made changes concerning debt mutual funds. As per the new rule, a mutual fund where not more than 35% is invested in equity shares of an Indian company will now be deemed to be short-term capital gains. This will apply to investments made on or after April 1, 2023.
Also, debt funds held for more than 3 years will no longer enjoy indexation benefits. Additionally, they won't be eligible for a 20% tax rate. In other words, regardless of holding period, debt mutual funds will be taxed according to the investor's tax bracket.
Why this change by the government? According to experts, the change will result in tax parity between 100% debt mutual funds and bank fixed deposits.Also, the government may want to tax the gains arising on the transfer, redemption, or maturity of such debt mutual fund units in the same manner as interest income from bank FDs at normal slab rates.
Impact of indexation removal on debt mutual funds: Moderately Negative
As per CLSA, below are the impacts of the change on the debt mutual funds:
- This is a negative for the MF industry having non-liquid debt AUMs of ~Rs 8 trillion (19% of AUMs) – as the relative attractiveness due to tax arbitrage goes away.
- Liquid MFs of Rs 6.6 trillion will not be impacted materially as they are anyways a short-term product and there is no material change in tax attractiveness.
- The revenue contribution from non-liquid debt products is 11-14%. Brokerage firm CLSA believes that this is moderate to low impact as the bulk of the revenue/profitability for AMCs comes from equity AUMs and non-liquid debt AUMs are neither higher growth nor higher profitability segments for AMCs.
Positive impact for banks - but too small?
With the proposed changes (it is yet to be passed as a bill) for debt MFs, tax arbitrage vs bank deposits is gone. Therefore, people who invested in the debt funds to avail of indexation benefit may shift to bank deposits as FDs carry the additional advantage of being free of interest rate risk. It is a positive impact on the bank but the quantum cannot be very high as bank deposits’ market size is Rs 180 trillion vs total debt MF size of Rs 8 trillion.
Conclusion
Experts believe that the new rule will have a significant impact on debt mutual funds. Investors may no longer be interested in debt funds and may move to equity funds. Alternatively, money may be directed towards bank fixed deposits, sovereign gold bonds, and non-convertible debentures in the debt category.
This is not investment advice. Investments in the securities market are subject to market risk, read all the related documents carefully before investing. Past performance is not indicative of future returns.