Investors in debt mutual funds will have to pay short-term capital gains tax from April 1, signalling the end of a regime that granted them the benefits of indexation that had made it a popular investment option.

The change in the tax treatment on debt mutual funds comes into effect after the Lok Sabha passed the Finance Bill 2023 on Friday without any discussion on the 64 amendments to the country’s direct and indirect tax regime that were introduced through finance minister Nirmala Sitharaman’s budget on February 1.

The widely expected fallout according to market analysts is a rise in the popularity of bank fixed deposits, the returns on which in the form of interest are also taxed at the slab rates of an individual.

Investors in debt mutual funds at present pay tax on capital gains at redemption. The applicable rate of tax depends on the period of holding. If the period of holding is less than 36 months, the gains are treated as short-term capital gains and taxed at slab rates.

If the period of holding is more than 36 months, the gains are treated as long-term capital gains and the tax rate is 20 per cent with indexation benefit.

From April 1, 2023, any gains from debt funds will be treated as short-term and taxed at slab rates.

Earlier in the budget, the government had moved to treat gains from market-linked debentures (MLDs) as short-term capital gains through a new section 50AA of the Income Tax Act.

The amendment to Finance Bill 2023, now also mentions specified mutual funds under this section. This includes any mutual fund where not more than 35 per cent of proceeds is invested in the shares of domestic companies. This will include debt mutual funds and gold ETFs.

Finance secretary T.V. Somanathan said the move was aimed at bringing parity with instruments which are of a similar nature.

FDs will gain

Analysts in the mutual fund industry expect nearterm redemption pressure on these funds and a move towards bank fixed deposits, corporate bonds and more riskier equity instruments.

They have also started recommending investors to make their investments before March 31, 2023 to avail themselves the indexation benefits.

“This will have a huge impact on the tax you pay because indexation will no longer be available for calculating your gains. Indexation of capital gains is essentially inflation adjustment. It is not a tax exemption, nor a gift from the government. It is inflation compensation for the fact that the value of money degrades over time,” said Value Research CEO Dhirendra Kumar in a note adding that without indexation benefit, if an individual is in the top tax bracket, practically all real gains will be taken away by the government.

“This will also affect gold funds and international funds. As a result, bank fixed deposits will become more attractive as both debt funds and bank fixed deposits will be subject to the same taxability of maturity proceeds,” said Manish P. Hingar, founder at Fintoo.

“With the tax arbitrage gone, retail investors will stick to fixed deposits over debt funds. The potential for mark to-market gains at the cost of higher market and credit risk is just not enough of a premium for investors. They might as well stick to hybrid or equity schemes for their riskier allocations,” said Gautam Kalia, senior vice-president at Sharekhan by BNP Paribas.

“For mutual funds to get investor interest, it’ll now have to purely be on their ability to add extra ‘risk-adjusted returns’ and not because of any tax arbitrage. The tax arbitrage that was available at an ‘instrument’ level seems to be getting evened out across the board be it debt MF or MLD,” Srikanth Subramanian, CEO, Kotak Cherry, said.

“This will benefit the corporate bond market where there will be renewed interest from retail investors, and this will also add depth to the liquidity which again will mean better pricing for the end customer,” he said.

“The amendment will substantially diminish the attractiveness of debt MFs. The rationale of treating them at par with MLDs is not very clear,” said Punit Shah, partner, Dhruva Advisors.

STT clarification

The finance ministry on Friday clarified that the securities transaction tax (STT) on selling options in the derivatives market will be increased to 0.0625 per cent from 0.05 per cent.

There was a typographical error in the amendments to the Finance Bill 2023 which was approved by the Lok Sabha earlier in the day.

In the bill, it was mentioned that STT will be raised from 0.017 per cent to 0.021 per cent.

The amendments moved by finance minister Nirmala Sitharaman provided marginal relief to taxpayers opting for deductions and exemption-free new tax regime: individuals earning marginally higher income than the no-tax ceiling of Rs 7 lakh will continue to pay nil tax.

Under the new tax regime with effect from April 1, if a taxpayer has an annual income of Rs 7 lakh s/he pays no tax. But if s/he has income of Rs 7,00,100 s/he pays tax of Rs 25,010. Thus an additional income of Rs 100 leads to tax of Rs 25,010.

The amendment provides that the tax payable should not be more than the income that exceeds Rs 7 lakh. This means an individual having income up to Rs 7,27,700 could stand to benefit from this marginal relief.

The tax deducted at source (TDS) on online gaming applications will now be effective from April 1, 2023 versus the earlier provision of July 1, 2023, according to Finance Bill 2023 amendment.

Credit Cards

Sitharaman said it has been represented that payments for foreign tours through credit cards are not being captured under the Liberalised Remittance Scheme (LRS) and they escape tax collection at source.

She said the RBI is being requested to look into this with a view to bring credit card payments for foreign tours within the ambit of LRS and tax collection at source thereon.

The amendments have brought some relief to real estate investment trusts (REITs) and infrastructure investment trusts (InvITs) by softening the impact of the tax on distributions classified as return of capital.

The budget had proposed taxing such distributions, in their entirety, at the marginal tax rates in the hands of unit holders. Under the amended laws, only a portion of such distributions or a “specified sum” will be taxed. The specified sum is arrived at after taking out the cost of acquisition from the distributed amount.