Finance Bill: How will new Mutual Fund rules impact investors from April 1?

The Centre amended the mutual fund rules in the Finance Bill, 2023, on Friday. The debt mutual fund (Debt MF) investors will no longer receive the long-term capital gain tax benefit. They will be taxed like bank deposits. It will be applicable from April 1.

The amendment to the Finance Bill was passed in Parliament today.

What are the current rules of taxation on mutual funds?

Currently, debt fund investments of over three years qualify for long-term capital gains tax. Their gains are taxed at 20 per cent with indexation benefits or 10 per cent without indexation. Investments of less than three years qualify for short-term gains tax, and the investor has to pay tax at his slab rate.

Indexation offers major tax benefits to investors, especially in the case of high inflation.

What is indexation?

Indexation is a process by which an investor can account for inflation in the gains made in debt funds to reduce total tax outgo. It is done through a mechanism that uses the cost inflation index (CII). The CII adjusts the purchase price of an asset for inflation in the year of its sale.

It calculates taxes after accounting for inflation. So, in a high-inflation environment, the tax liability reduces significantly. Currently, India is facing high inflation, and thus indexation is all the more relevant.

What are the new mutual fund rules?

According to the amendment, debt funds with less than or equal to 35 per cent invested in equity shares will be taxed at the investors' income tax slab and treated as short-term capital gains. This is similar to how bank deposits are taxed in India.

Moreover, the debt mutual fund investments will also not allow indexation from April 1 in the above-mentioned case.

Investors mainly opt for debt funds because of the tax advantage they offer over fixed deposits (FDs).

"It will be treated more like FD income and taxed accordingly in the hands of an debt fund unit holder," Maneet Pal Singh, partner, IP Pasricha and Co told Business Standard.

The new changes will also apply to gold, international equity and even domestic equity fund of funds (FoFs).

"Debt mutual funds had a favourable tax regime as compared to banks' fixed deposits and small savings," Amit Maheshwari, a tax partner at AKM Global, told Reuters that debt mutual funds will now be taxed at par with other investments. "This could impact debt mutual funds investments in corporate bonds."

Maheshwari said that this proposed move is targeted mostly towards high net-worth individuals who were using this investment as a tax-saving instrument.

Why the new rules?

"It is apparent that the government intends to remove tax arbitrage by creating a consistent tax policy across all debt instruments. In this regard, the government has proposed a similar taxation policy for insurance product (savings) maturity proceeds, wherein annual premiums exceeding Rs 5 lakh will be taxed post March 31," said Manish Hingar, founder at Fintoo.

Who will be impacted by the change?

"Bringing the tax implication on long term investment in debt oriented fund at par with the bank FD appears to be a big blow for the debt market which is still in nascent stage and a push towards equity market," said Geetanshu Bhalla, director of The Virtual Compliance.

"Amongst retailer investors, senior citizens seem to be affected most who can enjoy 80TTB deduction annually on interest on Fixed Deposit but not on gain on debts funds," he said.

However, he added, the proposed provision may neither affect the investment strategy of new or younger investors who invest in debt funds for a shorter period to get higher returns nor HNIs or Corporates whose strategy in investment is not much impacted by tax implications.

"We may see a shift from long-term debt funds to equity funds, and money may be directed towards sovereign gold bonds, bank fixed deposits, and non-convertible debentures in the debt category. This is good news for banks as they can attract customers with higher interest rates and increase their borrowing and saving book sizes," Hingar said.

"The investors will be tempted towards two extremes of risky investments under equity mutual funds or the safer havens of Bank fixed deposits.The investors will therefore have lesser choices although the exchequer may gain with extra tax revenues," said Jyoti Prakash Gadia, managing director (MD) at Resurgent India.

Who is protected from the new changes?

All existing or new investments made before March 31 will not be affected by the proposed mutual fund tax change.