Government scraps long-term tax benefit for debt mutual funds investing less than 35% assets in equity

The government made the proposal in the form of an amendment to the Finance Bill 2023, which was passed in Parliament today

The Centre has removed tax benefits on mutual funds with less than 35% investment in equity.

The government has scrapped the long-term capital gains treatment (with indexation benefits) for income from debt mutual funds and other schemes that invest upto 35% in equity shares of domestic companies.

The returns from such funds will now be treated as short term capital gains. Currently, capital gains arising from transfer of mutual fund units, other than equity-oriented funds held for more than three years, are considered as long-term investments and taxed at 20% with indexation benefits.

“An arbitrage is being created right now where interest income from debt mutual funds (where not more than 35% invested in shares in domestic company) is not distributed and converted into long term capital gains of 20% (with indexation). In some cases, it comes to even less than 10% due to indexation,” the Finance Ministry said in a note explaining amendments to the Finance Bill.

Noting that many taxpayers are able to reduce their tax liability through this arbitrage, the government has now extended tax provisions introduced in the Budget 2023-24 for market-linked debentures, to such debt funds.

“The amendment will treat gains from transfer of units of specified mutual funds as short term and tax them at slab rates,” said Tapati Ghose, partner at Deloitte India. “The proposed move seems to bring taxation of such mutual funds on par with bank deposits and will impact such investments made on or after 1 April 2023,” she said.

Noting that these tax changes will also apply to categories such as gold funds, international funds and domestic fund of funds that have an equity exposure of upto 35%, VK Vijayakumar, chief investment strategist at Geojit Financial Services said there will be far-reaching consequences.

“This proposed reform mainly targets high net worth investors and family offices who gained from the tax arbitrage under the existing tax regime. More investors will opt to put their money into bank fixed deposits, equity mutual funds and hybrid funds that invest over 35% of their portfolios in equity and Sovereign Gold Bonds,” he noted.

While the move may hurt some mutual fund products, these changes simplify the tax system by taxing all fixed income products alike, Mr. Vijayakumar said.

Roopali Prabhu, chief investment officer and executive director, private wealth group at JM Financial, said investors will have to take higher risks due to this shift.