Debt Mutual Funds are Now at Par with Fixed Deposits for Taxation

Mar 24, 2023 / Reading Time: Approx. 7 mins

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The Lok Sabha passed the Finance Bill 2023 without discussion while the opposition continued with its stir demanding a Joint Parliamentary Committee (JPC) on the Adani-Hindenburg issue.

With this, the government has had its way in doing away with the tax benefit on the Long Term Capital Gains (LTCG) tax on debt-oriented mutual funds if they invest less than 35% of their assets in equities.

Thus now with effect from April 1, 2023, debt mutual funds will stand at par with bank fixed deposits with respect to the tax treatment. In other words, the tax efficiency enjoyed by debt mutual funds on the LTCGs until now will be lost.

Currently, if your holding period is less than 36 months in the case of a debt-oriented mutual fund, you pay Short Term Capital Gain (STCG) tax as per your tax slab (i.e., the marginal rate of taxation). So, if you are in the highest tax bracket you end up paying as high as 30.9% tax.

However, when if the holding period in the case of a debt-oriented mutual fund is 36 months or more, on the realised gains --classified as Long Term Capital Gains--you, the investor, pay 20% LTCG tax with the indexation benefit + 4% health & education cess and the applicable surcharge.

For NRIs, the capital gains on debt-oriented mutual funds are subject to Tax Deduction at Source (TDS) at the rate of 20% for LTCG and 30% for STCG.

Short-Term Capital Gains STCG Tax Long-Term Capital Gains LTCG Tax
Non-equity-oriented mutual funds
(Debt-oriented mutual funds)
Less than 36 months As per your tax slab 36 months and above 20% (with indexation benefit)

How was indexation helping so far?

The indexation benefit (based on the cost on inflation index under Section 48 of the Income Tax Act, 1961) provided you with the benefit of adjusting the purchase price of an investment to reflect the inflation impact on the purchase value. This effectively reduced your LTCG tax liability.

Debt Mutual Funds are Now at Par with Fixed Deposits for Taxation
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But now, with effect from April 1, 2023, the government has removed this indexation benefit. As such the gains would be taxed as per your income-tax slab (just like the way STCG on debt mutual funds are taxed).


The impact of the change in tax rule...

The tax arbitrage, used by some smart investors to their advantage, has been done away with. This is a deterrent for debt mutual funds, as it eliminates the tax efficiency over bank FDs, particularly for holding the investment for the long term.

Your existing investments in debt-oriented mutual funds made before March 31, 2023, shall not be impacted by the aforesaid change in tax rule. It will mainly impact investments made on or after April 1, 2023.

With interest rates moving up, and prospects of some further increase (if the RBI perceives the risk to the inflation trajectory), fixed deposit and Small Savings Scheme (SSS) rates may get further attractive and, thus, one may see outflows from long-term debt funds. Investors won't hold to their debt funds for 3 years; they would consider exiting investments anytime after making capital gains and pay the capital gain tax thereon as per their income-tax slab.

Those investing for the short-term may, of course, continue approaching Liquid Funds, Ultra Short Duration Funds, Low Duration Funds, Short Duration Funds, Money Market Funds and other sub-categories of debt mutual funds.

What should be your investment strategy now to invest in the Indian debt market?

On balance, the six-member Monetary Policy Committee (MPC) of the RBI is of the view that further calibrated monetary policy action is warranted to keep inflation expectations anchored, break core inflation persistence, and thereby strengthen medium-term growth prospects. The MPC has decided to remain focused on the withdrawal of accommodation to ensure that inflation remains within the target going forward while supporting growth.

But given that CPI inflation is cooling off and the fact that RBI has increased the policy repo rate (by 250 basis points) successively since May 2022, it appears we have almost peaked out on the interest rate cycle. Perhaps a 25-bps rate hike during the MPC meeting of April 2023 cannot be ruled out. However, there is a consensus that RBI might hit the pause button before taking any decision to cut the policy rates.

The debt markets, in my view, have already priced in aggressive rate hikes and going forward, the volatility on long-term bonds could be limited, it makes an opportune time to get into duration funds with a medium-term view. Depending on your liquidity needs you could look at short to medium-duration debt funds. That said, keep in mind that investing in debt funds, in general, is not risk-free, and hence prefer the safety of the principal over returns. Avoid investing in debt funds that engage in yield hunting to clock higher returns.

Alternatively, if you prefer to keep your capital safe, opt for bank fixed deposits, but choose the bank carefully.

Also note that change in tax rule not just applies to debt-oriented mutual funds, but even to gold, fund of funds and international funds, which are essentially classified as non-equity mutual fund schemes from a taxation point of view.

So, be a thoughtful investor. Invest considering your risk profile, tax bracket you are in, investment objectives, financial goals, and time in hand to achieve those envisioned goals.

Happy Investing!


ROUNAQ NEROY heads the content activity at PersonalFN and is the Chief Editor of PersonalFN’s newsletter, The Daily Wealth Letter.

As the co-editor of premium services, viz. Investment Ideas Note, the Multi-Asset Corner Report, and the Retire Rich Report; Rounaq brings forth potentially the best investment ideas and opportunities to help investors plan for a happy and blissful financial future.

He has also authored and been the voice of PersonalFN’s e-learning course -- which aims at helping investors become their own financial planners. Besides, he actively contributes to a variety of issues of Money Simplified, PersonalFN’s e-guides in the endeavour and passion to educate investors.

He is a post-graduate in commerce (M. Com), with an MBA in Finance, and a gold medallist in Certificate Programme in Capital Market (from BSE Training Institute in association with JBIMS). Rounaq holds over 18+ years of experience in the financial services industry.

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