Impact of Tax Changes on Debt Funds: What Investors Need to Know? | Espresso


Decoding latest tax changes in debt funds – how it impacts investors, mutual funds, and corporate bond market

April 20, 2023
Decoding latest tax changes in debt funds – how it impacts investors, mutual funds, and corporate bond market

The government has withdrawn the indexation benefits on long-term capital gains (LTCG) enjoyed by debt mutual funds, through an amendment to the Finance Bill, 2023. From April 1, 2023, capital gains on debt funds, irrespective of the holding period, are to be taxed at an individual’s personal income tax slab rate.

The new tax rules are effective prospectively, and the government has allowed the benefit of ‘grandfathering’. This means an investor’s purchase price will be the first day of the new rule.

What this means for debt funds and its investors?

The amendment has brought debt funds, that invest less than 35% in equity shares, at par with fixed deposits and bonds in terms of taxation.

Let’s quickly understand what tax benefit debt funds enjoyed over fixed deposits earlier.

Before the introduction of the new rules the tax on gains from debt funds depended on the holding period of the investment. Gains made from sale of a debt fund within 3 years of purchase were considered short-term capital gains and taxed at the investor’s personal income tax slab rate.

However, any gains made from sale of a debt fund after 3 years of purchase was considered long-term capital gain and taxed at 20% with an indexation benefit. Indexation helps adjust the cost of investment after accounting for inflation, improving post-tax returns for debt funds.

Fixed deposit interest, on the other hand, is taxed at an individual’s income tax slab rate. So, if taxable income is in the highest tax slab i.e., 30%, then that is what investors pay on FD interest.

Stripping off the tax benefits on debt mutual funds has created a level-playing field for all fixed-income products and has led to speculations that many retail investors may move to other debt products like bonds, fixed deposits, and even hybrid mutual funds. Hybrid funds are funds with equity investment between 35% and 65%.

Debt mutual funds play a significant role in the development of retail participation in the country’s debt capital market. The new regulation will somehow impact the retail flows into debt funds but is unlikely to have a significant impact on institutional flows into debt funds.

However, the liquidity of the bonds market in India has been an issue for a long time despite debt funds directing a substantial amount of money into the bond market. With the possibility of investors potentially shifting their funds towards fixed deposits, long-term investments in debt funds will likely be impacted.

Impact on bond market

Debt mutual funds typically invest money in bonds and debentures, among other fixed-income securities. The reduced demand for debt mutual funds could hit the funds’ ability to invest in corporate bonds, potentially leading to decreased demand for corporate bonds in the market.

If the demand for corporate bonds falls, it could impact the issuance and pricing of corporate bonds. Reduced demand may result in higher borrowing costs for corporates issuing bonds, as they may need to offer higher yields to attract investors.

What data suggests

The data from Association of Mutual Funds in India (AMFI) for the month of March 2023 showed debt mutual funds witnessed an outflow of Rs 56,884 crore, the highest in six months. In the calendar year 2023 so far, the debt category has seen total outflows of Rs 81,015.51 crore.

In the debt category, investors shifted their focus to long-duration funds. The liquid funds witnessed net selling of Rs 56,924.13 crore during the month, the highest net outflows in the income/debt-oriented category. Investors prefer liquid funds to park their money for short periods of time typically one day to three months.

However, Corporate Bond Funds, which invest in long-term debt issued by companies, saw buying to the tune of Rs 15,626.16 crore. Banking and PSU bond funds, long-duration funds, dynamic bond funds and gilt funds witnessed significant inflows, mostly due to the change in the taxation rules.

It is believed that savvy investors with funds available may have opted to lock in funds for more than three years to take advantage of the window before the taxation rules changed in April. With the interest rates likely near their peak, the benefits can prove to be multi-fold.

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R. Kalyanaraman
by R. Kalyanaraman

Chief Executive Officer

I am a sales guy at heart with utmost willingness to listen to people – customers, employees, competitors et al. Nothing gets me a bigger adrenaline rush than an interesting conversation with my customer!