What changed on 24th March 2023 on mutual fund taxation?
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.
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Which categories of mutual funds are impacted by the rule change?
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.
International: funds that invest in international stocks or ETFs
Hybrid: hybrid funds like conservative hybrid, multi-asset and dynamic asset allocation funds
Gold/Silver: gold and silver mutual funds and ETFs
Fund of Funds: any fund of fund that invests in a combination of equity or debt funds or both equity and debt funds
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:
STCG: at marginal tax rate if held for less than 3 years
LTCG: at 20% with indexation benefit if held for more than 3 years
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.
Which mutual funds still have indexation benefits?
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
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.
Should investors continue to invest in debt mutual funds when indexation is not there?
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.
Should investors invest in FDs instead of debt mutual funds now that indexation is not there?
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.
Should investors stop investing in gold funds after 1st April 2023?
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.
Should investors invest in SGB instead of 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.
Should investors invest insurance plans instead of debt mutual funds?
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.
Should investors switch to hybrid funds for debt exposure?
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.
Should investors invest in arbitrage funds instead of liquid or money market funds?
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.
Should investors stop investing in international funds?
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.
How should investors change their investment strategy after 1st April 2023?
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.
Disclaimer: Content on this site is for educational purpose only and is not financial advice. Nothing on this site should be construed as an offer or recommendation to buy/sell any financial product or service. Please consult a registered investment advisor before making any investments.
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