New Debt Mutual Fund Rules in India to Take Effect on April 1, 2023

On March 24, 2023, changes were introduced to the mutual fund regulations via the Finance Bill 2023, which indicates that investors in debt mutual funds will no longer be eligible for the long-term capital gains (LTCG) tax advantage and will be taxed similarly to bank deposits. Moreover, these proposed changes will also be extended to gold, international equity, and domestic equity funds of funds (FoFs). The changes will be implemented on April 1, 2023.

What are the new taxation rules in India for debt mutual funds applicable from April 1, 2023?

As per the latest amendment, debt funds with 35 percent or less investments in equity shares will be regarded as short-term capital gains and taxed at the income tax slab of investors.

Although this move has disappointed mutual fund investors, it is intended to create a consistent tax policy for all debt instruments and remove tax arbitrage. Additionally, the government has suggested a comparable tax policy for insurance savings products, with maturity proceeds being taxed for annual premiums exceeding INR 500,000 after March 31, 2023.

However, current and new investments made before March 31 will not be affected by this proposed tax change. According to tax experts, this proposal may bolster bank fixed deposits.

How are mutual funds currently taxed under the existing taxation rules?

Currently, mutual funds are taxed based on the duration of the investment. Investments in debt funds held for over three years are eligible for long-term capital gains tax, taxed at 20 percent with indexation benefits or 10 percent without indexation. Short-term gains tax applies to investments held for less than three years and is taxed at the investor’s slab rate.

Indexation is a crucial aspect of taxation in mutual funds as it provides significant tax benefits to investors, particularly in high inflation scenarios. Indexation allows investors to account for inflation in their debt fund gains, ultimately reducing their overall tax liability by using the cost inflation index (CII). This index adjusts the purchase price of an asset for inflation in the year of sale, resulting in reduced tax liability in high-inflation environments. Currently, India is experiencing high inflation, making indexation even more relevant.

How will the proposed changes impact investors?

• Long-term investment in debt-oriented funds will now have the same tax implication as bank fixed deposits, pushing investors towards the equity market and impacting the nascent debt market.
• Senior citizens, who can annually enjoy an 80TTB deduction on interest from fixed deposits, will be affected the most.
• New and younger investors who invest in debt funds for a shorter period and high net worth individuals (HNIs) or corporates whose investment strategy is not much impacted by tax implications may not be affected.
• Investors may shift from long-term debt funds to other investment options, including equity funds, sovereign gold bonds, bank fixed deposits, and non-convertible debentures in the debt category.
• Banks stand to benefit as they can attract customers with higher interest rates and increase their borrowing and saving book sizes.
• Investors will be tempted towards either risky investments under equity mutual funds or safer havens like bank fixed deposits, resulting in fewer choices, and the exchequer may gain extra tax revenues.