Tax Tweak in Finance Bill Dulls Debt Mutual Funds: CRISIL
Moneylife Digital Team 25 March 2023
The Union government's amendment to the Finance Bill has done away with the long-term tax benefit of indexation for debt mutual funds (MFs). According to the amendment, debt MFs have been stripped of the long-term tax benefit if they invest less than 35% of their assets in equities. Such MFs will attract short-term capital gains (STCG) tax.
The amendment brings the taxation treatment for debt MFs on par with similar investment options like bank fixed deposits (FDs), where the capital gains are added to the investor's income and taxed at his or her slab rates.
Institutional investors accounted for 70% of investments in debt MFs as of December 2022. Individual investors, particularly high-net-worth individuals (HNIs), also raised their stakes in the category, with a 27% share. Moreover, the passive fund category of target maturity funds was gaining traction.
In a note, CRISIL Ratings says the new rule could prompt investors to reassess their investments in debt MFs. "The amendment divides mutual fund categories into three segments, as opposed to two previously. The new segment consists of funds that invest between 35% and 65% in equities. On the positive side, in the newly formed segment, mutual funds could introduce more asset-allocation products, thereby expanding the range of products available to investors in the medium to long term."
"Furthermore, with the tax advantage for debt mutual funds gone, product development and fund management (i.e. returns) will become the focal point determining investment flow among the available options," it added.
At present, in accordance with the Securities and Exchange Board of India (SEBI)'s categorisation and rationalisation of MF categories, only balanced hybrid funds by structure are permitted investments between 40% and 60% in equity and equity-related instruments.
A mutual fund house is allowed to offer either an aggressive hybrid fund or a balanced fund. Considering the preferential treatment given to equity MFs, most fund houses have chosen the former. 
"Debt mutual funds worked on three principles as an investment: returns, liquidity, and tax arbitrage. The tax benefit distinguished them from conventional debt instruments such as bank fixed deposits, which could now get a boost," CRISIL says.
Indexation benefit was applied to debt MF investors with an investment horizon of more than three years. Investors were subject to taxation at 10% without indexation and 20% with indexation, thus reducing the overall tax liability from their capital gains in debt MFs.
Indexation was applied based on the cost inflation index (CII), and took into account the prevalent inflation in the country based on the consumer price index (CPI).
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