What are the changes in LTCG for debt mutual funds?
Starting from April 1, 2023, capital gains on certain debt oriented mutual funds (that invest less than 35% in equities) — will be added to your taxable income and taxed at your applicable slab rate. Long-term capital gains (LTCG) tax benefits and indexation benefits on these debt mutual funds are no longer available.
Any capital gain on redemption of a debt fund held for three years or more was considered a long-term capital gain until March 31, 2022. Such long-term capital gain was taxed at 20%, along with indexation, bringing the effective tax rate to less than 20%.
What is indexation benefit?
Indexation factors in inflation and adjusts the purchase price of investments upward, hence reducing the tax liability. It was allowed to be used for calculating capital gains on certain long-term investments, including debt funds.
Due to indexation benefit, debt mutual funds were considered an excellent fixed-income investment option compared to other debt investment options.
For instance, you invested in a debt fund in January 2020. Your investment amount was ₹10,000, and you bought the units at a NAV of ₹10. Three years later, in March 2023, you redeem your investments at a NAV of ₹20. Thus, when you sold your investments, the value of your investments was ₹20,000. Your investment made capital gains worth ₹10,000.
However, you don’t need to pay tax on this entire amount of ₹10,000. Since your holding period was three years, indexation will reduce the value of your LTCG. To calculate the Indexed Cost of Acquisition (ICoA), you use the following formula:
ICoA = Original cost of acquisition * (CII of the year of sale/CII of the year of purchase)
In the above-mentioned example, the indexed cost of acquisition will be ₹11,561, i.e., (10,000 * 348/301).
Thus, instead of ₹10,000, your capital gains will now be ₹8439, i.e. (₹20,000 – ₹11,561).
Thus, using indexation benefit, you managed not to pay tax on ₹1561 of your gains.
Which are the types of mutual fund schemes affected by the change?
As per the changes, long term capital gains will no more be applicable to gains from mutual funds that invest less than 35% in equity from April 1, 2023, and hence indexation benefit will also not applicable for them.
Debt mutual funds with more than 35% but less than 65% equity exposure, held for 3 years or longer will still be eligible for long term capital gains to be taxed at 20% with indexation benefit.
So what does it mean for debt Mutual Fund investors?
Changes will not affect short-term (less than three years) investors in debt mutual funds as prior to the change in capital gains calculation also, taxation at the slab rate was applicable for debt fund investments shorter than 3 years.
For long-term (equal to or more than three years) debt fund investors, indexation is no longer available in above mentioned categories. This could make some debt mutual funds less attractive as an investment option for a few investors, and bring them at par with other debt instruments such as FD, corporate bonds, etc.
However, debt investments made before April 01, 2023, will not be affected.
How will the tax be calculated post-amendment?
With the tax arbitrage removed between above mentioned categories of debt funds, bonds and FDs, the three are now taxed similarly, at the individual’s tax slab rate. This may lead to some long term debt investors, especially those in high tax brackets, considering a gradual shift towards equity funds for longer term durations or allocate funds to other fixed income instruments as well.
Even after the removal of the indexation benefit from March 31, 2023, debt mutual funds still offer several benefits over traditional fixed-income investments such as a diversified portfolio, market linked yields, professional money manager, etc.
Although the taxation part has changed, that doesn’t mean one should not prefer debt mutual funds as a means of investing, especially for short term investments and often the good funds yield better returns than comparable duration large bank fixed deposits also. Nonetheless, it is always advised to assess the suitability to your risk profile and financial goals before investing in any instrument.
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