This article shows the way forward for investors in debt, gold, hybrid and international funds which have lost indexation benefits on units purchased after 1st April 2023.
Disclaimer: Taxation is a dynamic concept. Investors should take professional guidance from their advisors to make necessary portfolio changes.
This article is a part of our detailed article series on the concept of mutual fund taxation in India. Ensure you have read the other parts here:
This article shows how to calculate the tax on selling inherited shares and equity mutual funds using the grandfathering concept.
This article is expected to give investors in India a complete guide on the topic of calculation of taxes on mutual funds.
This articles discusses some benefits and drawbacks of storing your mutual funds in demat mode with one killer feature that makes transmission possible.
This article shows you how the concept of indexation lowers the capital gains tax you pay when you sell debt mutual funds.
This article settles the question of which type of capital gain calculation is better - debt-type funds taxed at 20% with indexation vs equity-type at 10%.
This article explains the concept of equity LTCG grandfathering in detail with multiple case studies and examples.
This article talks about understanding capital gains tax calculations and computing offsets vs other income.
This post discusses the concept of tax calculations and tax harvesting in a simple manner.
The Finance Ministry, in a surprising move, made all profits taxable at slab rate from most mutual funds that previously had long-term capital gains taxed at 20% post indexation. This rule applies only to units purchased after 1st April 2023. The 20%-post-indexation rule is still applicable to units purchased before 1st April 2023.
With the rule change, the government has plugged the tax arbitrage that existed when investors invest in bonds or FDs (certificate of deposit route) via mutual funds versus holding them directly. For example, as per Budget 2023, the returns (and not death benefits) from traditional i.e. non-ULIP insurance policies with annual premiums above ₹5 lakhs and purchased after 1st April 2023 are taxable.
The following mutual fund categories are now taxable at the investor’s marginal tax rate or slab rate for all holding periods for units purchased after 1st April 2023. As a result, all mutual funds in the following categories have the same tax calculation irrespective of how long they are held. This change has come in due to adding Section 50AA in Budget 2023 which said that capital gains on Specified Mutual Funds (defined as funds holding no more than 35% in domestic equity or equivalent equity arbitrage position) will always be considered short-term and taxed at slab. These funds are:
Therefore, the rule applies to any mutual fund with a lower than 35% holding in Indian stocks. For any unit in these funds purchased before 1st April 2023, the taxation will continue to be:
As always, a surcharge is applicable on any tax paid as per current taxation rules.
This change in taxation also removes the double indexation benefit where investors could invest in these funds before 31st March and sell after 1st April, and with a total holding period of more than 3 years, to get an extra year’s worth of indexation.
Only balanced hybrid funds still have 20% tax with indexation benefits for units sold after 3 years. SEBI defines this category of mutual funds as those that have:
40% to 60% investment in equity & equity related instruments; and 40% to 60% in Debt instruments
To understand how to apply indexation, you can refer to this article: How to calculate taxes from capital gains and combine them with your other income
Equity mutual funds do not have indexation benefits and are taxed as follows:
Equity mutual funds, to whom the above tax rule applies, have greater than 65% holding in Indian shares:
In the hybrid categories of arbitrage, equity savings, and balanced hybrid funds, the >65% allocation is maintained by taking derivative positions, usually via cash-and-carry arbitrage.
Capital gains in equity mutual funds are grandfathered for all units purchased before 31st March 2018: Pay lower capital gains taxes for equity: understand how grandfathering works
Please refer to this article for more details on mutual fund taxation: How is tax calculated on selling shares/MFs and how do to do tax harvesting?
To modify Benjamin Franklin’s quote,
the only thing more permanent than death and taxes is changing tax laws
Taxation is dynamic and is liable to changes in the future. For example, even equity funds might come under the slab rate in the future. Therefore, any investment decisions based solely on taxation rules rather than investors’ needs may backfire. Today, we only know for sure that units purchased before 1st April 2023 are exempted from the rule change and will have work on that basis only without any speculation on future changes.
As predicted, some of these changes have now been reverted in Union Budget 2024 declared on 23-Jul-2024: Union Budget 2024: What are the changes in capital gains tax for Stocks and Mutual Funds?
The purpose of debt mutual funds is to provide stability and income in a portfolio. When rebalanced with risky asset classes like equity, debt allocation lowers portfolio risk or improves return.
Debt mutual funds, unlike FDs, still offer deferment of capital gains to the time of sale instead of yearly tax on accrual basis which reduces FD returns. Also, debt funds can be sold for any amount where the whole FD needs to be broken with penalties. Unless an absolute certainty of return is needed, and this is again need-based and not tax-based, FD should not be chosen over debt mutual funds.
If the investor’s portfolio requires an allocation to gold, and this is a need-based and not tax-based decision, then investors should invest in gold mutual funds.
If the SGB maturity aligns with the investor’s goals, they may be chosen instead of debt mutual funds since the SGB is tax-free. SGBs can also be purchased from the secondary market via a demat account in case there is no primary offering currently open from RBI.
Traditional non-ULIP insurance policies with less than ₹5 lakhs in annual premium are still tax-free. However, unlike debt mutual funds, they come with lock-ins, high charges and commissions. Investors will be better off purchasing a term insurance plan for life cover and investing outside insurance for long-term goals.
The hybrid categories like arbitrage, equity savings, balanced advantage and aggressive hybrid funds are taxed like equity funds which will be generally lower than the investor’s marginal rate. As long as the investor’s asset allocation for the goal is the same as that of the investment, these hybrid funds may be chosen.
Arbitrage funds hold 65% in Indian equities via derivative positions. They are taxed like equity funds which will be generally lower than the investor’s marginal rate. They also hold 35% of the portfolio in bonds of different maturities which might make their returns slightly unpredictable. As long as investors understand how arbitrage funds work, they can be chosen for short-term goals due to lower tax.
The increase in tax has not changed the diversification benefits of international funds. If you are convinced that you have a robust rationale for choosing international funds in your portfolio, you should continue investing..
The key here is to have a plan for investing and not act in a knee-jerk fashion. Investors in doubt regarding their next steps should contact a financial advisor for professional guidance or the author for a friendly chat.
AMCs are expected to tweak the fund mandates of the impacted funds by increasing Indian equity exposure directly or via derivatives. Until then, investors should stop lump-sum investments in these funds after 1st April 2023.
SIPs may also be paused though 1-2 months of investment at a higher tax rate, if the fund changes its mandate after that, will not make any material difference in extra tax.
Read the next part of this article here about a tweak that you can make in your investment strategy to lower the impact of the new tax rules: How to invest in mutual funds which are taxed at slab rates from 1st April 2023
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This post titled What should debt, international and gold mutual fund investors do now that these funds are taxable at slab rate? first appeared on 26 Mar 2023 at https://arthgyaan.com
