Debt mutual funds had slowly started to gain popularity in India as an alternative to traditional savings products such as fixed and recurring deposits. This is mainly down to the superior return profile, liquidity and tax efficiency offered by debt mutual funds relative to long term bank deposits. And logically speaking, picking debt mutual funds over bank deposits has rightly been a more prudent thing for most investors to do. But a recent ammendment proposed by the government to Budget 2023 has threatened to severely compromise the popularity of debt mutual funds relative to long term bank deposits.
The ammendment in question proposed to bring in a significant change to the way gains from debt mutual funds would be taxed in the hands of investors, starting from 1st April 2023. And it has since been passed in the parliament and made effective from 1st April 2023. This change has created a lot of doubt in the minds of those who currently invest in debt mutual funds. Therefore today I am going to throw light on what the change in the taxation of debt mutual funds is, how the situation could evolve going forward and what investors should do with their debt mutual fund investments going forward.
Until 31st March 2023, gains from debt mutual funds were taxed at a special rate of 20% with an indexation benefit if held for 3 years or more before selling. The indexation benefit adjusted gains for inflation, meaning investors would have to pay lesser taxes. This made debt mutual funds an attractive option for those falling in the highest tax bracket. But as per the ammendment that has been introduced, gains from debt mutual fund units purchased on or after 01-04-2023 would be taxed at slab rates applicable to the investor, regardless of the period of holding before sale.
This means that investors would lose the benefit of being taxed at a special rate, and having their gains adjusted for inflation which reduced their tax bill after the stipulated holding period of 3 years. Needless to say, those in the highest tax bracket and those investing in debt mutual funds solely for their beneficial tax treatment would be hit the hardest by this development. This is because the ammendment brings the taxation status of debt mutual fund on par with bank deposits. To understand the impact of the ammendment on the final tax outgo of investors, take a look at the calculations given in the graphic that follows.
We live today in a day and age where financialisation is of utmost importance in India. Financialisation basically involves moving household savings in India away from traditional investment avenues and physical assets towards the capital market and financial assets. And for financialisation to be effective, we need to have robust and well regulated capital markets across all asset classes. In light of these facts, the move to bring the tax status of gains from debt funds on par with bank deposits can only be called an unexpected one from those in power. This is because such a move does not reward investors adequately for taking on capital market risk in the debt space.
This would detract from the strength of the bond market in India, precisely at a time when retail investors in India need to be encouraged to move away from traditional bank deposits and contribute to strengthening India's bond markets. Nevertheless, the best thing that we can do now would be to look forward and understand what is being done and what we need to do in order to adapt to this sudden change. And this process starts with us making peace with the change in tax status of debt funds. Because as investors, we must understand that changes in taxation of investment products whether positive or negative, are a given from time to time.
Of course, the move has not been welcomed by most in the mutual fund industry. Various Asset Management Companies (AMCs) and regulatory bodies such as the Association of Mutual Funds in India (AMFI) are expected to make their representations to both the Finance Ministry and SEBI in the coming days as to the detrimental effects of the recently introduced changes, and why they should be rolled back. But ultimately, all such efforts are highly unlikely to lead to any change of note. So the sooner we prepare ourselves mentally for what is all but certain to come, the better.
The new tax regime would apply to debt funds where less than 35% of the assets in the fund are parked in Indian equity. This would broadly categorise mutual funds into 3 groups from 01-04-2023 onwards, based on the degree of exposure to Indian equity within the fund. For convenience and ease of understanding, I have classified them as follows.
This effectively means that among non equity funds, the tax change would only apply to Class B Funds. The tax treatment of Class A Non Equity Funds would remain the same even post 01-04-2023, meaning that gains from Class A funds would continue to be taxed at a special rate of 20% with an indexation benefit when sold after being held for 3 years or more. If we were to assume that the new regime of debt fund taxation is not rolled back by the government, it would be logical to say that it would be upto SEBI and Asset Management Companies to realign their debt fund offerings in accordance with the new regime of debt fund taxation.
Asset Management Companies have already started to realign their mutual fund offerings to the changed tax regime by changing the investment approach (technically called the investment mandate) of their funds. In most cases, this would allow investors to continue to enjoy long term capital gains, special rates of taxation and indexation benefits (wherever applicable) beyond 01-04-2023. For instance, Quant Dynamic Asset Allocation Fund, which was a non equity fund, has recently changed its investment mandate such that it becomes a pure equity fund from 01-04-2023 onwards.
In effect, the implications of the changed debt fund tax regime would no longer be applicable to Quant Dynamic Asset Allocation Fund, thanks to this change. Other AMCs may also announce such moves in the coming days. SEBI themselves can play their part to help investors after the chat introduced by the government. In theory, SEBI can relax the categorisation rules it has in place for mutual funds. This give AMCs more room to modify the investment mandate of their offerings in a way that is beneficial to investors. For instance, SEBI categorisation rules currently allow each AMC to offer an aggressive hybrid fund or a balanced hybrid fund, but not both.
Removing this rule would allow each AMC to offer at least one balanced hybrid fund, which would be classified as a Class A Non Equity Fund. Such funds would not be taxed as per the new regime, which would in turn be beneficial to investors. Whether or not SEBI actually makes any such changes will only be revealed over time. This just leaves the question as to whether investors should make changes to their debt portfolios in light of the changes in the way debt funds would be taxed. It is important to remember that the only thing that should dictate a major change in our portfolios are our financial goals and the asset allocation strategies for those goals.
Those of us who were investing in debt funds simply for their superior tax status relative to bank deposits were simply investing in debt funds for the wrong reasons. Picking debt mutual funds based on pure investment merit in light of our goals rather than tax benefits becomes much more important now. And as far as tax benefits are concerned, it is important to remember that even though gains from debt funds would now be taxed at slab rates, they would only be taxed at the time of redemption. In most cases, this would still allow investors to enjoy a lower tax liability relative to bank deposits, thanks to the benefits of compounded returns in the years before redemption.
This clearly means that there is no need for knee jerk reactions on our part as investors, at least until we have better clarity on how events evolve with regard to the new tax regime for debt funds. In fact the changes that have been introduced have made taking well thought out decisions that are based purely on goal based investment merit all the more important when it comes to our debt portfolios. And though investors may no longer be able to enjoy the benefits of a lower rate of taxation on debt mutual funds, the benefits of better compounded returns and deferment of taxation compensate for it to a certain extent.
Add to that the flexibility and liquidity that debt mutual funds offer in terms of redemption relative to bank deposits, and there is a very strong case that can be made for continuing our investments in debt mutual funds, even with the implications of the newly introduced changes in the way they would be taxed going forward. So the only changes that are warranted in our debt mutual fund investments going forward would the reasons for which we include debt funds in our portfolios and ensuring that the right kind of forethought precedes those choices. Everything else would continue to remain the same until and unless there are concrete and logical reasons that necessitate a significant change to our investment strategy.