Any gain on a mutual fund with less than 35% exposure to domestic equity will be considered short-term capital gain, irrespective of your holding period.
This new tax rule has been introduced as an amendment to the Finance Bill, 2023 and has come as a shock to investors.
In this post, let’s understand the change and how this affects your investment planning.
This change in tax rule takes away the biggest advantage of debt funds over bank fixed deposits. Do we still have aspects where debt funds score over bank fixed deposits?
Which fund categories are affected?
An obvious answer here is debt funds.
Why?
Because debt funds don’t invest in stocks. They invest in bonds.
What is the problem?
More taxes on gains.
As per the current structure, short term capital gains (holding period up to 3 years) on debt funds are taxed at your marginal tax rate (tax slab).
Long-term capital gains (holding period > 3 years) will be taxed at 20% after indexation.
As you can see, LTCG gets the benefit of indexation and gets taxed at a relatively lower rate too.
Let’s consider an example.
You invest Rs 1 lac today in a debt mutual fund.
After 4 years, this amount grows to Rs 1.4 lacs. A total gain of Rs 40,000.
Since the holding period is greater than 3 years, this gain is long term capital gain and will get indexation benefit.
Let’s say the Cost of Inflation index (CII) in the year of purchase (FY2023) is 331 and in FY2027 is 380.
Your indexed cost of purchase will be = 380/331* 1 lac = Rs 1.14 lacs
Long term capital gain (taxable) = Sale price – Indexed cost of purchase = Rs 1.4 lacs – Rs 1.14 lacs = Rs 26,000
On this LTCG of 26,000, you pay 20% tax. 20% of 26,000 = Rs 5,200
As per the new rule, there shall be no concept of Long term capital gains for debt funds.
Hence, any gain irrespective of the holding period shall be considered and taxed as short-term capital gain.
In the above example, the gain of Rs 40,000 will be considered short-term capital gain. And if you are in 30% tax bracket, you will have to 30% * 40,000 = Rs 13,333 as tax.
Does this affect my existing debt mutual fund investments too?
No.
Your existing debt mutual fund investments or those debt MF investments made on or before March 31, 2023 will still be eligible for indexation. For such investments, short term capital gains (holding period up to 3 years) will be taxed at your marginal tax rate (tax slab). Long-term capital gains (holding period > 3 years) will be taxed at 20% after indexation.
For debt MF investments made on or after April 1, 2023, there is no concept of long-term capital gains. All gains shall be taxed as short-term capital gains and at marginal income tax rate.
The Collateral Damage
This new tax rule just does not affect the debt mutual funds.
It affects all the mutual funds with less than 35% in equity. And not just any equity. It must be domestic equities.
Thus, a few categories apart from debt funds that will be impacted are as follows.
- Gold mutual funds and ETFs
- International equity FoFs
Since the stated intent of the move is to tax interest income in any form as interest income (and not as capital gains), gold MFs and international equity FoFs seem to be merely collateral damage. I hope there is a rethink on this part.
This also affects conservative hybrid debt fund category where at least 75-90% of investments must be in debt instruments. If you have 75-90% in debt instruments, you can’t have 35% in equity.
Earlier, there were two kinds of mutual funds for tax-classification purposes. With less than 65% equity exposure. AND with 65% and above equity exposure.
Now there are 3.
Who does this affect the most?
Clearly, if you are in higher income tax brackets. 20%-40% marginal tax rate.
For the debt MF investments made on or after April 1, 2023, you must pay tax on all the gains at the marginal tax rate. No concepts of long-term capital gains and indexation benefit.
I have been investing in debt funds and advising clients to invest in debt funds. Because of favorable tax treatment. Hence, this one hits close, and requires a rethink on fixed income allocations.
Who is not affected?
If you are in 0-10% income tax bracket, you are not affected as much. Even after indexation benefit, your net tax liability would be somewhere in that range only. Hence, you should be fine.
If you are making investments in debt funds only for the short term (< 3 years), then the new tax rule does not impact you.
Short term capital gains in debt funds are taxed at marginal income tax rate. And will be taxed at marginal tax rate even after April 1.
What becomes more attractive after the new Debt Fund Tax rule?
#1 Bank Fixed deposits
For me, the biggest reason to choose debt funds over bank FDs was favourable tax treatment. Once you take away the favourable tax treatment of debt funds, much of the merit debt funds have over bank FDs goes away.
A Bank FD is perhaps the simplest investment product. Debt funds are way more complicated. Selecting a right debt mutual fund may also be easy for most investors.
A bank FD also carries no risk (at least the way things work in India). Can’t say the same for debt mutual funds. While you can select debt funds that carry very low risk, debt funds can never provide the safety comfort that bank FDs offer.
#2 Arbitrage Funds
Arbitrage funds have the risk and return profile of a debt fund but tax treatment of an equity fund. The new tax rule does not affect their tax treatment. Short term gains are taxed at 15% and long-term gains are taxed at 10%.
#3 Direct Bonds
Instead of debt mutual funds, you can invest directly in bonds. You can buy short term treasury bills and even Government bonds with maturity up to 40 years and lock-in the rates of interest. Hence, you can build a fixed income portfolio using direct bonds depending on your requirement and preferences.
The drawback of investing directly in bonds was that the interest used to get taxed at the marginal rates. Debt funds offered better. Now, with favourable tax treatment to debt funds withdrawn, you can consider owning bonds directly (and not through debt MFs).
#4 Hybrid products
This one is complicated, but I do not expect the MF industry to take this blow sitting down. Expect a slew of launches which can workaround the new tax rule. A conservative hybrid product with arbitrage exposure (that takes equity exposure to 35%). Or any other similar product.
We still need to see if SEBI MF classification rules permit such a product.
I am usually not in favour of investing in such products.
#5 Traditional life insurance plans
If you are a regular reader, you know I do not like these plans. For poor returns. Lack of flexibility and exorbitant exit costs.
The issues with such plans persist. However, their maturity proceeds are still tax-free subject to conditions. And an investment choice is always relative.
With the indexation benefit of debt funds taken away, a few investors may find merit in tax-free guaranteed returns of non-participating plans (despite their shortcomings). This must be seen on a case-to-case basis.
Where Debt Mutual Funds still score over Bank Fixed Deposits?
While the biggest benefit of debt funds has been taken away, there are still many advantages that debt funds offer.
#1 Tax liability comes only at the time of redemption
In case of bank FDs, you pay tax on interest every year, whether you use the interest or not. The banks also deduct TDS on interest paid. So, if you are currently working and are in the 30% tax bracket, you pay 30% tax on this interest.
In case of a debt fund, the tax liability will only come at the time of sale. And gains at the time will still be taxed at 30%. However, there is a possibility. With debt funds, you can choose the time of redemption and thus you control (to an extent) the tax rate to be paid.
What if you were to sell this investment after your retirement when your tax bracket has fallen to 0% or say 5-10%? You will have to pay a much lower tax rate.
#2 Your money compounds better in debt mutual funds
Since the tax is only at the time of redemption, this also helps compound your money better.
So, if you invest Rs 100 in a Bank FD and earn 10% interest, you pay Rs 3 in tax in the first year (30% tax bracket). So, in the second year, you earn returns on Rs 107 (it will be on Rs 109 since TDS is 10% but then you have to pay Rs 2 deficit tax from your own pocket).
In debt funds, since the tax liability is only at the time of redemption, you will earn returns on Rs 110 in the second year.
#3 When you sell debt funds, the proceeds include both principal and capital gain
You put Rs 10 lacs in a bank fixed deposit. Interest rate is 10%. You need Rs 1 lac per annum.
The bank pays you 1 lac per annum (10% * 10 lacs). Yes, the bank will deduct TDS but let’s ignore it for now. If you are in the 30% tax bracket, you will pay 30,000 in taxes.
Contrast this with debt mutual fund. You invest Rs 10 lacs in a debt MF at NAV of Rs 100. You get 10,000 units. After 1 year, the NAV has grown at 10% (let’s say) to Rs 110 per unit. Total value = 11 lacs.
You redeem Rs 1 lac from the investment.
For that, you will have to sell, 1/11* 10,000 units = 909 units
Total short-term gains = 909 * (110-100) = Rs 9,090.
At 30% tax, you pay tax of Rs 2,727.
With bank FD, you paid Rs 30,000.
Now, you might argue that eventually you must pay similar levels of tax. While with FD, you pay the same amount every year. With debt funds, as the gain accumulates, the tax impact will go up. That’s right.
However, this is more flexible. Helps compounding since you are delaying taxes. And we must also account for the possibility that your marginal tax rate may come down after you retire.
#4 Debt funds are so much more flexible than Bank FDs
You anticipate an expense in the family, but you do not know the exact date. Let’s say a wedding in the family. Could happen in 2 months, 6 months, 12 months, or 18 months.
If you want to go with an FD, what should be the tenure of the FD? 3 months, 6 months, or 12 months? What are the interest rates? 4% p.a. for 3-month FD, 5% p.a. for 6-month FD, 7% p.a. for 12-month FD.
You find that the 12-month FD pays the most and go for it. But then, you need money just after 3 months. You will have to break the 12-month FD. The bank will not only give a lower rate (as you would have earned on a 3-month FD) but also charge a penalty. Your plan was to earn 7% p.a. but you earned (4% -0.5% penalty =) 3.5% p.a. for 3 months
Debt funds don’t discriminate. If the YTM at the time of investment was 7% p.a. and didn’t change thereafter, you will earn 7% p.a. for those 3 months.
Another point: You open FD of Rs 10 lacs. After a few months, you need Rs 2 lacs from this investment. You can’t break your FD partially. If you break, you lose out on higher interest and pay an interest penalty. Again, no such issues with debt funds.
Yet another: To me, it feels cumbersome to manage so many FDs. And you will end up with many FDs if you must invest every month. Yes, you can use a Recurring deposit to reduce burden. But RDs won’t help if your cashflows are not as predictable. With debt funds, you can simply keep adding to the same fund.
#5 Debt fund will short term capital gains that can be set off against short term losses
This is a weak argument for choosing debt funds over bank FDs, but I will still put this down.
Debt fund returns will come in the form of short-term capital gains. Now, STCG can be set off through short term capital losses from any other asset (equity, debt, gold, real estate, foreign stocks).
Hence, if you have done a lousy job with your other investments, you might be able to set those off against the gains in debt funds.
While the biggest advantage of debt funds over bank fixed deposits has been taken away, there are still some merit in debt mutual funds. You need to see if those merits are good enough reasons for you to invest in debt funds.
What you must do?
#1 Invest before March 31, 2023, if possible
If you are sitting on cash and want to invest in debt funds over the next few months, suggest you do that on or before March 31, 2023, so that this investment is eligible for indexation until you exit it. I assume you will hold this for long term (more than 3 years)
Even if you are unsure about how you will use the cash, suggest you park this money in debt funds before March 31, 2023. You can always take this out later if required. Investing now makes you eligible for long term capital gains tax.
#2 MF redemptions work on FIFO (A new folio or a new scheme)
Debt investments you made before March 31, 2023, are precious since these are eligible for indexation benefit. However, MF redemptions work on FIFO (first-in, first-out) basis.
Let’s say if you are investing in HDFC Liquid fund.
When you redeem from this fund, the oldest units will be sold first. But you don’t want to sell the older units since those are eligible for indexation benefit.
You want to sell the newer units (bought after April 1, 2023). How do you do that?
- Invest in a different scheme (ICICI Liquid instead of HDFC Liquid). Sell first from ICICI Liquid if the need comes OR
- Continue to invest in HDFC Liquid but in a new folio. If you need money, sell the units from the new folio first.
#3 Target Maturity Products (TMFs) have a unique problem
Target maturity debt funds are great products since you can lock-in the YTMs (almost) at the time of investment. This happens because of the product structure and because these funds have a set maturity date.
So, if you are investing in these products before March 31, 2023, note that when the TMF investment matures, the subsequent reinvestment won’t be eligible for indexation benefit. Contrast this with a product with infinite life (say a liquid fund, money market funds). You can continue to hold money in this investment for 20-25 years and still be eligible for indexation.
If you are investing in TMFs after March 31, 2023, all gain is short-term gain. That’s the same for any debt MF. However, for TMF, all the money from a particular TMF will come in the same year, which might increase your marginal tax rate (or even inflict surcharge). To avoid such a situation, you can do 2 things. Spread your money across multiple TMFs. OR spread out your redemption from a particular TMF i.e., you can consider taking some money out before maturity. This is less of a problem with debt funds with infinite lives since you can control redemption.