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Pure Debt Mutual Funds Stripped off Indexation Benefits

Submitted by admin on April 11th, 2024

In respect to a key change in the finance bill 2023, the GOI made some major changes in mutual fund taxation to give pure debt mutual funds the kind of treatment similar to how Fixed Deposits are treated. The sudden changes did not trigger any feel-good sense in most investors.

The new rule dictates that a mutual fund where investment in domestic companies’ equity shares has not exceeded 35 percent of its total yields will be categorized as “Specified Mutual Fund” and the tax will be levied on it at the marginal rate (according to your slab).

However, the proceeds from these specific mutual funds will still come under the category of “short term capital gain” and not as “interest” income, favouring debt funds.

Rule Came into Effect from April 1, 2023

The change applied to only new investments made after April 1, 2023. Old investments were immune to any impact after the change came into effect.

So, in case you already have a debt fund, you can hold it and will be able to receive the indexation benefits. The feature makes it a good investment window.

It is noteworthy that we still enjoy the indexation benefits for the funds having equity exposure ranging from 35-65%.

Which funds were affected?

The following categories do not receive the indexation benefits:

• GOLD ETF

• Liquid Fund
• International Fund of Funds
• Dynamic Asset Allocation Funds
• Conservative Hybrid Mutual Fund

The funds tied to global investments are still considered as debt funds and hence, are heavily affected in times of taxation because they don’t have investment in “domestic equity”. Their portfolio contains equity though it’s not domestic. As a result, they are not treated as equity funds.

Why did GOI make such a change?

The government rationalised their decision by claiming that the debt funds were enjoying a strong indicative returns and credit risk was absent in their case, which would bring them a predictive return and treat them at par with Fixed Deposits. It means, the government is against any preferential treatment.

This may sound a bit odd because investors still have interest rate risk on debt funds and the default risk, even though small, still exists.  Anyone investing in debt fund still has investment in a market link product and should receive additional benefits though the GOI holds a different view.

What does the change mean for retail investors?

The change will affect the investors having heavy dependency on debt funds as a part of their long-term investment planning as well as those searching for a safe investment option tied to high tax advantage and low risk.

Most of the investors invested in debt funds for short-term benefits and monetary gain is possible in 2-3 years.

Advantages of Pure Debt Funds

Though the taxation benefit of debt funds has been struck off, there are 3 significant advantages of debt fund and hence, it is aptly considered as a “Capital Gain” as listed below:

Liquidity: You can withdraw money from a debt fund anytime without having to pay penalty (after the primary 1-3 months).

Tax not on accrual but on withdrawal: Unlike FDs, taxation can be postponed in future.

Setoff gains with losses: Capital gains are adjustable.