Decoding Finance Bill proposals for debt funds: What remains and what changes

The Finance Bill 2023 has announced an amendment that will classify capital gains arising from debt mutual funds as only short-term capital gains. The government has said that investment in mutual fund where not more than 35 percent is invested in equity shares of Indian company (which is debt funds) will now be deemed to be short-term capital gains. This means long-term capital gains will go away.

Also, debt funds held for more than three years will no longer enjoy indexation benefits. Additionally, they won't be eligible for a 20 percent tax rate.

This will be applicable to investments made on or after April 1, 2023.

As of now, debt mutual funds are treated as long-term investments if held for more than 3 years and taxed at the rate of 20 percent along with indexation benefits or 10 percent without indexation. Those with a holding period of less than 3 years are taxed according to their tax slab.

With the changes, investments in debt mutual funds will be taxed as short-term capital gains only. There will be no indexation benefit and tax at a 20 percent rate.

Any profit or gain that arises from the sale of a ‘capital asset’ comes under the category ‘income from capital gains’, and hence individuals need to pay tax for that amount in the year in which the transfer of the capital asset takes place. This is called capital gains tax.

The two types of Capital Gains are short-term capital gains tax (STCG) and long-term capital gains tax (LTCG).

STCG are the profits that individuals earn when they sell off their capital assets before one year of holding those. Long-term capital gains (LTCG) are the profits that individuals earn when they sell off their capital assets post one year. It is applicable at 20 percent except on the sale of equity shares and the units of equity-oriented funds. It is 10 percent and above on the sales of equity shares and units of equity-oriented funds.

With the proposed changes, this will not be the case with debt funds now.

Indexation helps investors to bring down taxes as it calculates the taxes after accounting for inflation. With the amendments, debt funds held for more than three years will no longer enjoy indexation benefits.

Experts say that these changes are proposed to bring bank fixed deposits (FDs) on-par with debt mutual funds. Currently, debt fund investors enjoy a tax advantage over FDs.

"A lot of investors underprice credit risk and invest in corporate debt over FDs enamoured by the favourable taxation. These changes will lead to an increase in the yield on corporate debt for investors to get the same after-tax returns. If corporates are unwilling to bear this then we will see a lot more flows going into FDs," said Gaurav Rastogi, CEO & founder at Kuvera.in.

Another point to note is that retail investors are currently not that big in the fixed income category. This means institutional clients and HNIs would be mostly hit.