Negative Impact of Debt Mutual Fund Tax Changes
(The author is a CFA Charterholder from CFA Institute, USA. This is just for information purposes only. This should not be construed as tax advice. Safe to assume the author has a vested interest in financial products discussed here. Investors should consult their own investment / tax advisor before making any investment decisions.)
(please see updates 04Oct2023 and 03Apr2023 at the end of the article)
On 24Mar2023, PM Modi government brought some last-minute amendments to Finance Bill, 2023 in the Indian Parliament. One of the negative surprise from the amendments is the removal of tax benefit that debt mutual funds (debt MFs) currently enjoy with regard to long term capital gains (LTCG) tax.
It may be mentioned the Finance Bill, 2023 was originally presented to parliament on 01Feb2023. And the tax amendments proposed on 24Mar2023 were not in the original bill presented on 01Feb2023, but subsequently added at the last minute.
2. Existing capital gains tax on debt mutual funds:
If you buy and hold a debt MF scheme for a minimum period of three years, and any gains you make by selling it after three years is considered as LTCG. And such LTCG is taxed at 20 percent with indexation benefits (indexation benefit means the acquisition cost of a debt MF scheme will be adjusted taking into account the cost of inflation -- to give relief to investors from the adverse impact of rising prices).
The existing LTCG tax is applicable only till 31Mar2023.
If you sell such a debt fund within three years of buying; any gains you make will be considered at short term capital gains (STCG). Such STCG will be taxed at your slab rate (investor's marginal tax) -- meaning if you fall under 20-percent tax bracket, such STCG on debt MF will be taxed at 20 percent and if you fall under 30-percent slab, the tax will be at 30 percent.
3. Proposed STCG / LTCG on debt mutual funds:
As per the amendments to Finance Bill, 2023 on 24Mar2023, effective from 01Apr2023 (from financial year 2023-24), there will be no distinction between short term capital gains (STCG) tax and long term capital gains (LTCG) tax of debt mutual funds.
From 01Apr2023, any capital gains investors make from debt mutual funds will be taxed at the slab rate (marginal tax rate) of the investor, irrespective of the holding period of the investment.
Suppose, if you buy a debt fund on 01Apr2023 and sell it the next day; any gain you make on the investment will be added to your income and taxed according to your tax bracket next year.
And if you sell such a debt fund after 10 years of holding, the tax treatment will be the same -- meaning any gains you make after 10 years will be taxed as per your tax bracket 10 years later (your tax bracket may change after 10 years -- which is a different issue).
The tax amendments made to Finance Bill on 24Mar2023 apply prospectively to debt MF investments made on or after 01Apr2023.
Debt MF investments made till 31Mar2023 will be grandfathered, meaning such investments will continue to enjoy LTCG tax as is being applicable now -- that is, such investments made till 31Mar2023 will continue to enjoy tax benefits mentioned in section 2 above.
4. Current status on the proposed tax amendments:
The proposed tax amendments to debt MFs, among other things, were approved in Lok Sabha (lower house of Indian Parliament) on 24Mar2023. It will be presented to Rajya Sabha (upper house) later. Once it is approved by Rajya Sabha and notified in Indian Gazette, the Finance Bill, 2023 will become a law.
5. Impact of the Tax Amendments on various mutual fund schemes:
One important caveat before you read this section 5: I have no tax expertise. This is based on my previous knowledge and various documents -- my information presented here may be wrong though I've taken reasonable care to avoid any mistakes.
The following four tables A, B, C and D will explain the impact of tax amendments: (it's better if you look at all the four tables comprehensively rather than piecemeal):
Table A: Equity MFs holding 65 percent or more of their total assets in domestic stocks: There is no impact on such funds from the new tax changes:
Examples: As you know, equity mutual funds are like, flexi cap funds, large-cap funds, mid-cap funds, thematic equity funds, sector-based funds, small-cap funds, tax savings schemes (ELSS), value funds and focused funds. Other funds that are included in Table A above are: aggressive hybrid funds, arbitrage funds and equity savings funds.
Table B: Mutual fund plans holding between 35 percent to less than 65 percent of their assets in domestic stocks: There is no impact on such funds from the new tax changes:
Examples: Funds included in Table B above are: Balanced Hybrid Funds and others.
Table C: Mutual funds that hold less than 35 percent of their assets in domestic stocks: such funds will be negatively impacted wef 01Apr2023 from the new tax changes:
Examples: Funds included in Table C above are: most categories of debt funds (like, liquid funds, money market funds, overnight funds, corporate bond, dynamic bond, credit risk funds, floater, gilt, conservative hybrid funds, etc.), gold funds, fund of funds (FOFs) and international funds.
Table D: Other debt funds like Balanced Advantage Funds (or, Dynamic Asset Allocation funds) and Multi Asset Allocation funds may fall in one of the three buckets mentioned in Table A, B and C above:
Examples: Funds included in Table D above are: Dynamic asset allocation funds (or, Balanced Advantage Funds), and multi-asset allocation funds.
6. Quixotic Changes by PM Modi Government Burdening Individual Taxpayers:
Some of the onerous changes made by the government in the past nine years in addition to the latest removal of tax benefit to debt mutual funds:
1. Indian government has been imposing,
for the past five years, both long term capital gains tax of 10 percent
on equities, in addition to securities transaction tax (STT) -- which
has been quite unfair.
Many government supporters
in 2017 / 2018 supported imposition of LTCG tax on equities. But
ultimately in Feb2018, they had to eat beef when the government
introduced LTCG tax of 10 percent on equities, while retaining STT.
Back then, one television-anchor-cum-banking expert argued in this article (before 2018 Budget) that both STT and tax on LTCG should co-exist because "investors allowed to set-off the STT against their capital gains."
2. Effective from financial year 2016-17, 10-percent dividend tax was introduced for dividend received in excess of Rs 10 lakh in a year (which was subsequently stood removed when dividends were made taxable, from financial year 2020-21, in the hands of individuals as per their tax slab)
3. Effective from financial year 2020-21, dividends received are made taxable in the hands of individuals as per their tax slab. This has pushed up the tax slabs of many taxpayers, negatively impacting their after-tax incomes (concomitantly, dividend distribution tax or DDT was removed).
And to make things worse for taxpayers, a 10 percent tax deduction at source (TDS) has been imposed since FY 2020-21.
4. Effective from July 2019, buyback tax of 20 percent has been imposed on companies, that distribute their cash surplus to shareholders through buyback of equity shares. And effective buyback tax is 23.30 percent (including 12 percent surcharge and 4 percent health & education cess).
5. There has been no change in the PPF (public provident fund) interest rate for the past 12 quarters. In April 2020, PPF interest rate was slashed, in a blow to senior citizens, from 7.90 percent to 7.10 percent per year. Ever since then, PPF interest has been kept at 7.10 percent, doing a huge dis-service to savers that too in the backdrop of stubbornly high inflation since October 2019.
The government has been violating its own policy of "market-determined" interest
rates on the small savings schemes, including PPF. Nothing the government does
is market-determined, much depends on political expediency and giving special support to their picky supporters.
(PIB press release dated 16Feb2016 on "market-determined" interest rates on small savings schemes)
6. Instead of making individual income tax simpler, a new tax regime runs in parallel to the existing tax regime for the past three years -- making taxpayers confused and confounded. If you opt for the new tax regime, you have to forego all the tax exemptions provided in the Income Tax Act, 1961.
With two tax regimes, we've more than 13 or 14 tax slabs to deal with, which is almost a world record of sorts!
That the government was forced to make the new tax regime "more attractive" in the Union Budget presented on 01Feb2023 is an indirect admission that the new tax regime has been a spectacularly failure (because not many were opting for new regime, the government had no choice but to increase some incentives).
Is it the objective of the government to discourage savings in India by removing tax incentives for various savings schemes and other items in the new tax regime? If it is so, the government has been doing a dis-service to savings rate.
Since 2013-14, India's savings rate has been falling precipitously. Savings rate and investment rate (GFCF or gross fixed capital formation) are inter-linked. Higher savings are required for higher investment rate.
The point is everything is linked to everything else in an economy. Unless governments take a comprehensive view on economic matters, it's hard to achieve all-round progress.
7. Till financial year 2017-18, we were paying education cess of 3 percent. Since 2018-19, we have paying 4 percent cess as health & education cess. Nobody is asking how much has been spent on improving health and education of citizens.
8. Effective 01Apr2016, the Government arbitrarily changed the half-yearly compounding to yearly compounding
on NSC small savings, whereby investors would be losing 20 to 25 basis
points of interest every year--amounting to substantial loss in five
years. (NSC - National Savings Certificates)
9. It's fair to say the government in the past three to four years has brought in some relief via small changes. But it's not my job to recount them, because there are several people who do such a job more enthusiastically.
7. Finally...
Governments are in the habit of making tax changes capriciously. The current government at the helm is no different -- maybe, this government has got higher propensity to do erratic changes more effectively and efficiently (meaning without any murmur from citizens).
As has been highlighted for several years, the government has got huge appetite for imposing taxes and cesses on citizens.
What is sad is there has been no discussion or debate about how various tax amendments that have been made over the years have been impacting savings rate in India. India has no social security on the lines of the USA or Europe (except some piffling schemes here and there).
In the absence of a social security net, individuals have to resort to take some risks via market-linked financial products. Maybe, it is the wish of the government to nudge individual taxpayers toward embracing bigger risk in order to achieve their financial and retirement goals?
- - -
P.S.: The following are added after the above blog was published on 25Mar2023:
Update 04Oct2023: Specified Mutual Fund:
After the approval of parliament, the above changes to debt mutual funds taxation became effective from financial year 2023-24 and the relevant section is Section 50AA of Income Tax Act, 1961.
As per Section 50AA: "Specified Mutual Fund" means a Mutual Fund by whatever name called,
where not more than thirty five per cent of its total proceeds is
invested in the equity shares of domestic companies.
It may be recalled debt MF investments made till 31Mar2023 will be grandfathered,
meaning such investments will continue to enjoy LTCG tax as is being
applicable now -- that is, such investments made till 31Mar2023 will
continue to enjoy tax benefits mentioned in section 2 above.
So, the definition of "Specified Mutual Fund" is applicable to debt fund investments, where not more than 35% of total assets invested in equity shares of domestic companies, and which are made on or after 01Apr2023.
Applicable sections for mutual funds are available at this TaxGuru article dated 17Sep2023.
Update 03Apr2023: After the above tax changes by the Government of India, investors poured in money, between 27Mar2023 and 31Mar2023, into bond mutual funds to lock in tax advantages that were available only till 31Mar2023 (for bond fund investments on or after 01Apr2023, bond investors would lose the favourable capital gains as explained in the above article).
Value Research article dated 03Apr2023 reported record net inflows of about Rs 39,325 crore (image below) into debt funds during the last week of March 2023.
The biggest beneficiaries of MF categories of net inflows are: Target maturity funds, corporate bond funds and Banking & PSU funds.
References:
SEBI definition of mutual funds:
SEBI Categorization and Rationalization of MFs: SEBI definition of all mutual fund plans, including debt mutual funds:
SEBI circular dated 06Oct2017 and SEBI circular dated 04Dec2017
Tweet 04Oct2023 - "specified mutual funds" - debt mutual funds taxation - Section 50AA of IT Act
Tweet thread 19Feb2024 - MF tax rates / mutual fund tax rates
Bandhan MF tax reckonery FY 2023-24
Tweet 02Jul2018 - MF tax rates for FY 2018-19
HDFC MF tax reckoner FY 2018-19
Tweet 15Apr2018 - SEBI Categorization and Rationalization
Why Are Equity Mutual Fund Investors Selling Out?
Dhirendra Kumar of Value Research Online on unfair tax on debt funds
Monika Halan on hasty removal of debt fund tax benefits
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Disclosure: I've vested interested in Indian stocks and other investments. It's safe to assume I've interest in the financial instruments / products discussed, if any.
Disclaimer: The analysis and opinion provided here are only for information purposes and should not be construed as investment advice. Investors should consult their own financial advisers before making any investments. The author is a CFA Charterholder with a vested interest in financial markets.
CFA Charter credentials - CFA Member Profile
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He blogs at:
https://ramakrishnavadlamudi.blogspot.com/
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