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Finance Bill 2023 amendment removes long-term capital gain benefit for debt mutual funds

Tax analysts and mutual fund industry participants say this will hamper growth of bond market, and potentially curtail avenues for fund-raising by companies.

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New Delhi: An amendment made to the Finance Bill, 2023, passed in the Lok Sabha Friday, has sought to bring debt mutual funds on a par with deposit instruments offered by banks as far as tax is concerned.

Mutual fund industry participants say this could hamper the growth of India’s still-nascent bond market, and also potentially curtail the avenues available to companies to raise funds.

Debt mutual funds or fixed-income mutual funds are so called because they invest in instruments like bonds issued by the government or by corporates that provide fixed returns. The other broad category of mutual funds is equity mutual funds which invest in shares of companies.

Prior to Friday’s amendment, if a debt fund’s instrument was held for more than three years, the investor would be liable to pay long-term capital gain (LTCG) tax on the profits at a rate of 20 per cent with indexation benefit.

In simple terms, indexation brings down the tax liability of an investor by factoring in inflation before the tax amount is calculated. In a high inflation scenario, indexation can significantly reduce the tax burden.

In contrast, gains from bank deposits, such as fixed deposits, are taxed at the income tax slab the investor falls in. That is, if the investor’s income places them in the 30 per cent income-tax slab, they will have to pay 30 per cent tax on the gains from their fixed deposits.

Now, with the change in the Finance Bill, gains arising from debt mutual funds will attract short-term capital gains tax, which is calculated in the same way as tax on bank deposits. So, if somebody falls in the 30 per cent income-tax bracket, they will have to pay that rate of tax on their earnings from their investment in debt mutual funds as well.

With anecdotal and industry inputs showing that the bulk of investors in mutual funds fall in the higher income-tax brackets, this means that the tax benefit that debt funds used to enjoy in comparison with bank deposits will no longer exist.

“Where the capital asset is a market-linked debenture, the full value of consideration received or accruing as a result of the transfer or redemption or maturity of such debenture… shall be deemed to be the capital gains arising from the transfer of a short-term capital asset,” the Finance Bill says.

The amendment made to the Bill Friday says this provision will apply to all mutual funds “where not more than 35 per cent of its total proceeds is invested in equity shares of domestic companies”. In other words, this change is applicable to debt mutual funds since equity mutual funds by definition have more than 35 per cent of their proceeds invested in equity.

An official in the Union Ministry of Finance told ThePrint that the reason behind the change was to remove the existing tax disparity between long-term investments in debt mutual funds and long-term deposits in banks.

“The gains from debt funds are in nature the same as the interest earned from a fixed deposit, but they were being taxed differently, and so we have rectified that,” the official said on the condition of anonymity, since he was not authorised to speak to the media.

A. Balasubramanian, managing director and chief executive officer at Aditya Birla Sun Life Mutual Fund, told ThePrint: “The rationale behind this move is in line with what the central government’s policy has been — to bring parity across all similar instruments.”

“The government has been working on bringing in a single-tier structure for all similar instruments, and this is a step in that direction,” he said, pointing out that this could have larger ramifications for both investors as well as the issuers of bonds.

“One of the reasons people were investing in fixed-income mutual funds was that they were getting the benefit of LTCG,” he explained, adding: “Now that advantage is not there. There are still some advantages to investing in mutual funds, but on the tax part, now they are on the same level as any other deposits offered by banks.”

Taxation experts ThePrint has spoken to, and who did not want to be named, said that without the taxation benefits debt mutual funds enjoyed over bank deposits, more people would start switching investments from mutual funds to banks, since banks are perceived as safer options.

Also read: Prudence over populism — why Modi govt must resist rolling out big-ticket schemes in Budget 2023

‘Likely to stagnate bond market growth’

A knock-on effect of Friday’s amendment is that companies that issue bonds will have to increase the interest rate they will have to pay investors so as to encourage them to choose bonds over bank deposits.

“Mutual funds provide a lot of funds to companies by investing in the bonds issued by them,” Balasubramanian said.

“These companies were able to raise funds at a cheaper rate than from banks because of the tax incentives given to investments in bonds. Now companies will have to raise the interest rates they offer on their bonds, which will make raising funds from bonds as expensive as raising funds from banks,” he added.

The MD & CEO of another prominent mutual fund company said this combination — of debt mutual funds no longer being as attractive to investors and making fund-raising more expensive for companies — would stagnate the growth of the bond market in India.

“For the last 20 years or so, the government has done a lot to encourage people to invest in bonds because this is an alternative way for governments and companies to raise funds, without having to go to the banks,” he said. “However, this will now stall because the mutual funds that invest heavily in bonds are being taxed at the same rate as bank deposits.”

Another impact, the MD & CEO explained, is that companies might see their avenues for fundraising curtailed since banks have prudential norms that specify limits on how much they can lend to any one corporate entity.

A third potential impact, he added, is that many debt mutual funds would now place at least 35 per cent of their investment in equity, which would expose investors in these mutual funds to the risks associated with the stock market.

(Edited by Nida Fatima Siddiqui)

Also read: RBI’s digital rupee concept has many pros, but also some risk to India’s financial stability

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