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Taxation on Debt Mutual Funds

By Ektha Surana

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Updated on: Mar 19th, 2024

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22 min read

Amendment to Finance Bill 2023 scrapped the indexation benefit on debt mutual funds. They will now be taxed at investor’s slab rates. These changes will bring the taxation of specified mutual funds at par with fixed deposits. Read on to know how this move may impact you and everything about the taxation of debt mutual funds.

What are Debt Mutual Funds?

Before diving into the changes, it is important to understand what are debt mutual funds and their current tax framework. Debt mutual funds are those investment instruments which predominantly invest their funds in fixed-income securities like bonds, debentures, and other debt instruments. These securities usually generate returns in the form of interest or capital appreciation, which makes them a preferred investment choice for conservative investors.

For taxation purposes, a specified mutual fund is defined as a mutual fund which invests less than 35% of its proceeds in the equity shares of domestic companies.

Taxation of Debt Mutual Funds after 1 April 2023

The Budget 2023 has brought about certain amendments that imply that a Specified Mutual Fund will no longer receive indexation benefits when computing long-term capital gains(LTCG). Therefore, debt mutual funds will now be taxed at the applicable slab rates. 

Moreover, indexation benefits will not be available for LTCG on gold mutual funds, hybrid mutual funds, international equity mutual funds, and funds of funds. Consequently, mutual fund houses are likely to be adversely affected as investors may prefer to invest directly in debt securities rather than debt mutual funds to avoid AUM fees/charges. The change may also impact the attractiveness of these mutual funds as an investment option, as the tax burden on the profits may increase.

Taxation of Debt Mutual Funds before 1 April 2023

Earlier, the taxation of debt mutual funds was governed by the holding period rule:

  • Short-Term Capital Gains: If the debt mutual fund unit is sold within 36 months (three years) of purchase, the gains are termed short-term capital gains (STCG). These short-term capital gains were taxed at slab rates. 
     
  • Long-Term Capital Gain: However, if they were sold after 36 months, then the gains were termed long-term capital gains (LTCG). These long-term capital gains were taxed at 20% with an indexation benefit. Indexation benefit means the gains made by investors were adjusted for inflation. This is illustrated in the table below.

How will the changes in income tax rules affect taxation on debt mutual funds?

Let us consider the tax flow on debt funds before and after the amendments.

Suppose Mr X invested Rs. 10,00,000 in FY 2020-21 in a debt mutual fund and sold the investments after three years of holding them in FY 2023-24 for a sale value of Rs. 20,00,000, thereby earning a capital appreciation value of Rs. 10,00,000. 

Particulars

Financial Year

Cost Inflation Index (CII)

Amount (Rs.)

Investment Made

2020-21

301

10,00,000

Sale

2023-24

348

20,00,000

Less: Indexed Cost of Investment

(10,00,000*348/301)

(11,56,146)

Long-term capital gain

(20,00,000-11,56,146)

8,43,854

Tax Payable

Tax @ 20%

1,68,770

Tax Liability in the same scenario but after the changes (from Financial Year 2023-24)

Particulars

Financial Year

Cost Inflation Index (CII)

Amount (Rs.)

Sale

2026-27

-

20,00,000

Less: Investment Made

2023-24

-

(10,00,000)

Short-term capital gain

-

10,00,000

Tax Payable

Assuming you fall in: 

- 30% tax bracket 

- 20% tax bracket 

- 10% tax bracket

 

3,00,000 

2,00,000 

1,00,000

Long-term capital gains tax before and after the recent changes in debt fund taxation:

Tax Bracket

Before amendments to the debt fund taxation rule

After amendment to the debt fund taxation rule

30% tax bracket

1,56,618

3,00,000

20% tax bracket

1,56,618

2,00,000

10% tax bracket

1,56,618

1,00,000

As seen in the above example, the recent changes to debt fund taxation will negatively impact people falling under the 20%-30% tax bracket.

Comparison of Fixed Deposits and Mutual funds taxation

Particulars

Fixed Deposits

Equity Mutual Funds  

(Equity: > 65% 

Debt: < 35%)

Debt Mutual Funds  

(Equity: <35% 

Debt: > 65%)

Old rule

New Rule

Types of funds

FDs

  • Equity funds
  • Aggressive hybrid fund
  • Balanced advantage funds
  • Arbitrage funds
  • All debt funds
  • Gold ETF
  • Multi-asset funds
  • Conservative hybrid fund
  • International FoF

What is Taxable?

Interest

Capital Appreciation

Capital Appreciation

Capital Appreciation

When is it Taxable?

Every Year on an accrual basis

Whenever you sell (redeem) the mutual fund units

Whenever you sell (redeem) the mutual fund units

Whenever you sell (redeem) the mutual fund units

Holding Period

-

12 months

36 months

-

Taxed at what rate?

At slab rates

- STCG: Slab rates 

- LTCG: 10% (on gains more than Rs 1 lakh)

- STCG: Slab rate 

- LTCG: 20% (with indexation benefit)

- Deemed to be STCG: Slab rate

Set off and Carry Forward of Losses

Not Allowed

Allowed

Allowed

Allowed

Are Fixed Deposits(FDs) better than Debt Mutual Funds?

Despite the recent developments that suggest debt funds are now comparable to fixed deposits, there are still several compelling reasons why debt funds can be a great tax-saving investment option: 

  • For instance, unlike fixed deposits, debt mutual funds are only subject to taxation when the investments are sold. Therefore, it can help you in deferring taxes.
  • Flexi FDs offer the flexibility to withdraw funds without penalty. However, if you opt for regular FDs, you may have to pay the penalty for early withdrawal. Conversely, debt funds impose no exit loads after a certain period. Therefore, debt funds provide greater liquidity and can be more cost-effective than Bank FDs.
  • Debt funds typically yield higher returns than fixed deposits.
  • Profits from Debt mutual funds are classified as capital gains, while fixed deposits are categorised as ‘income from other sources’. This means that in the event of losses with debt mutual funds, they can be carried forward and offset against gains.

Related articles:

  1. What are Debt funds and it's types?
  2. Debt Fund - Maturity and Duration
  3. Calculate tax liability on Debt Funds investments.
  4. Mutual Fund Taxation

Frequently Asked Questions

How can I show my debt mutual fund income in the ITR?

You can show the sale of debt mutual fund in schedule CG - capital gains.

Are indexation benefits removed from debt mutual funds ?

Yes, for all debt mutual funds purchased after 1st April 2023 any gains irrespective of holding period will be deemed to be short term capital gain and tax will be levied at slab rate. 

However any Debt mutual funds (Non Equity Mutual funds) purchased before 1st April 2023 old rule will continue to apply and if held for more than 3 years you will get the benefit of special rate @ 20%.

Will tax be deducted automatically from mutual funds ?

For Indian Tax Residents no tax will be deducted when you sell mutual funds or stocks. Thus any gains arising from such sale tax liability needs to be computed by taxpayers on their own and advance tax needs to be paid for any tax liability.

For Non Resident - TDS will be deducted by the brokerage depending upon the type of capital gain. Usually TDS will be computed on Gain transaction and on loss transaction such TDS will not be adjusted. Thus it might result into a refund which non resident can claim by filing ITR.

Am I liable to pay tax on the SWP - Systematic Withdrawal Plan?

Yes, SWP involves the redemption of mutual funds. If the units are sold at a higher value, then you are liable  for capital gain tax.

I have invested in a U.S Opportunity Mutual fund, i.e. Mutual fund which invests in Stocks listed on the U.S. Stock Exchange. Why is this considered a non-equity fund?

To Consider a Mutual fund as an equity-oriented, more than 65% of the assets need to be invested in Indian Listed Equity shares. Since the fund is investing in U.S Listed Equity shares, it is considered a Non-Equity fund, and any gain will be deemed to be considered a short-term capital gain. 

I have bought debt funds in FY 2020-21 and have sold it in FY 2023-24 after 3 years. Will I get the benefit of the old rule, Long-term capital gain with 20% Tax?

Yes, Amendment in Finance Act 2023 is applicable only for those investments made in Debt fund after 1st April 2023. Since you have invested before 1st April 2023, you are eligible to consider such sale as long-term capital gain and get 20% Tax with indexation benefit.

About the Author

Multitasking between pouring myself coffees and poring over the ever-changing tax laws. Here, I've authored 100+ blogs on income tax and simplified complex income tax topics like the intimidating crypto tax rules, old vs new tax regime debate, changes in debt funds taxation, budget analysis and more. Some combinations I like- tax and content, finance & startups, technology & psychology, fitness & neuroscience. Read more

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Quick Summary

Finance Bill 2023 scrapped indexation benefit on debt mutual funds, now taxed at slab rates. Impact on investors and comparison to fixed deposits. Changes on LTCG computations post-April 2023.

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