Buy debt mutual funds before March 31 to get indexation benefit

Long-term capital gains from debt, gold and foreign equity mutual funds will cease to enjoy the indexation benefit and lower tax rate from 1 April following an amendment to the Finance Bill 2023. Right now, short-term gains from investments held for less than three years are added to the income of the investor and taxed at normal slab rates. But if the investment is held for more than three years, the gains are classified as longterm capital gains and taxed at 20% after indexation.

Indexation takes into account the consumer inflation during the holding period and accordingly raises the purchase price of the asset. This in turn brings down the tax. During periods of very high inflation, the indexation benefit can reduce the effective tax significantly. This will change from 1 April when the amendment in the law comes into effect. Like short-term gains, the long-term gains from funds with less than 35% invested in domestic stocks will be added to the income of the investors and taxed at the normal slab rate of the individual.

The move has flummoxed mutual fund managers, investment advisors and tax professionals alike. “This is a big negative for retail investors not just in debt funds but also gold funds, conservative hybrid funds and international funds,” says Vidya Bala, head of research at Bala says retail investors were just warming up to the debt fund category but the new rule has changed the mood.

“The entire concession that debt funds enjoyed has been taken away. There is no reason to invest in debt funds anymore, except maybe in credit risk funds for higher yields,” says Amit Maheshwari, Partner in tax consultancy firm AKM Global. Maheshwari feels this change is more punitive than the 2018 tax on long-term gains from stocks and equity funds.

“With the tax arbitrage gone, retail investors will stick to fixed deposits over debt funds. The potential for MTM gains at the cost of higher market and credit risk is just not enough of a premium for investors,” says Gautam Kalia, Senior Vice-President at Sharekhan BNP Paribas.

Bala of Primeinvestor points to a bigger problem. Till now the long-term capital gains from debt and gold funds were taxed separately. “But if these gains will get added to your income, it could potentially push you into a higher tax slab and increase the tax outgo,” she says.

But investors have a small window of opportunity till 31 March, thanks to a grandfathering clause in the law. Chartered accountant Karan Batra points out that the amendment specifically says the new tax will apply to mutual fund units “acquired on or after 1 April 2023”. “If someone buys debt funds before 31 March, the investment will enjoy the indexation benefit till it is sold,” he says. If you were planning to invest in debt funds, make sure to do so before 31 March for greater tax efficiency.For the same reasons, hold your gold and debt funds in a hurry. While existing investments will continue to enjoy the indexation benefit, new investments made after 31 March will offer very low post-tax returns.

Even though the new rule has taken some of the sheen off debt funds, they still enjoy certain advantages over fixed deposits. For one, the gains from these funds can be set off against short-term and long-term capital losses on other investments. So if you made losses in stocks or gold, you can adjust them against the capital gains from debt funds.

There is also no TDS in debt funds. In fixed deposits, if the interest income exceeds Rs.40,000 in a year, the bank deducts 10% TDS. A taxpayer who is not liable to pay tax will have to submit either Form 15H or 15G to escape TDS. Debt funds are also very liquid. When you redeem your investment, the money is in your bank account the next day. Fixed deposits can also be prematurely closed, but you get a lower rate of interest. Also, debt funds allow partial withdrawals, unlike FDs where the entire investment is closed.

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