Tax On Debt Funds: FM Is Fixing Capital Gains Regime In Homoeopathic Doses

The Finance Ministry seems to have decided that reform of the capital gains regime is best done in homoeopathic doses.

This is one conclusion we can draw from the last-minute insertion of a clause in the finance bill to remove indexation for debt mutual funds. 

Investors will now pay taxes at the same rate as the tax bracket in which they are, which means up to 34 per cent on gains at the highest level, even if the funds have been held for longer than three years. In short, debt funds will be taxed as short-term gains if bought after 31 March 2023.

Under current tax law, any debt fund held for over three years qualifies for inflation indexation, and since inflation rates neutralise most of the positive returns on debt funds, investors pay very little or no tax on debt funds.

This works particularly well if they plan their exit dates to spill over to the start of a fourth fiscal year. 

It is possible that the higher tax-adjusted returns on debt funds impacted banks’ ability to raise fixed deposits more cheaply, but whatever the motivation — whether it was to help banks or clean up the capital gains regime — this is a good move.

The current capital gains regime has multiple interest rates and multiple tenures for determining long-term gains. For example, while debt funds attract long-term capital gains (LTCG) tax only after three years, equity and equity funds can claim long-term benefits after one year.

LTCG rates vary from 10 per cent on tax-free bonds held for three years, to 20 per cent for debt funds with indexation, to taxation at your bracket for many others. For property, the long term rate is 20 per cent for holding tenures of over 24 months.

One can also avoid tax altogether by investing the gains fully in another property. Short-term gains on equity sold through the stock markets is just 15 per cent.

Moving away from this thicket of multiple rates and tenures could ideally have been done in one or two stages, but the Modi government appears to have decided to do it in multiple stages so that no group of affected parties squeals too much.

In this case, banks will be happy, while mutual funds will be unhappy. Investors will merely switch to new modes of saving, since their current holdings in debt funds have been “grandfathered.” That is, investments made till 31 March 2023 will continue to receive the benefits of indexation and LTCG rates.

The more important reason for taxing debt funds is the need to align, at some future date, all incomes, whether derived from labour or capital investment. 

In the past few budgets, the Modi government has moved away from the UPA policy of issuing tax-free bonds, and taxing dividends at the bracket of the receiver instead of at the corporate level.

These helped the rich at the cost of the rest. Long-term capital gains from equity were brought under taxes in 2018 by the late finance minister Arun Jaitley.

Nirmal Sitharaman is continuing in this direction. One only wished it had been done sooner than later. But then finance ministers have to be careful how they pluck the tax goose: with a minimum of hissing and biting by those affected. Here, one cannot fault her moves.