Context: The government has proposed changes in taxation of debt mutual funds under which no benefit of indexation for calculation of long-term capital gains (LTCG) on debt mutual funds will be available for investments made on or after April 1, 2023.
From April 1, 2023, such debt mutual funds will be taxed at income tax rates as per an individual’s income. The move will remove the tax advantage a debt mutual fund has compared to bank deposits.
Consequences
- As a result, bank fixed deposits will become more attractive.
- This may have a negative impact on all debt funds, particularly in the retail category, as ultra-high net worth and high net worth individuals may choose to invest in safe havens like bank fixed deposits.
- There will be a loss to the bond market which is already struggling for the liquidity.
What is a mutual funds?
- A mutual fund is a pool of money managed by a professional Fund Manager.
- It is a trust that collects money from a number of investors who share a common investment objective and invests the same in equities, bonds, money market instruments and/or other securities. And the income / gains generated from this collective investment is distributed proportionately amongst the investors after deducting applicable expenses and levies, by calculating a scheme’s “Net Asset Value” or NAV. Simply put, the money pooled in by a large number of investors is what makes up a Mutual Fund.
What is indexation?
- Indexation is a process by which the cost of acquisition of an asset (mutual fund in this case) can be indexed (adjusted or inflated) over a period of time in order to bring it to current prices after taking inflation into consideration.
- Indexation is done through a mechanism using a Price Index which is adjusted for inflation. The Price Index adjusts for inflation at the time of purchase of an asset as well as at the time of its sale.
- It is a well-known fact that inflation erodes an asset’s value over a period of time.
- Indexation gives the investor an option to inflate (increase) the price of purchase of the asset. This helps in lowering the adverse cost impact due to inflation.
Indexation In Mutual Funds
- Mutual fund investments generate Capital gains (Capital gain is a gain or profit realized by way of selling a property or other such asset/investment). These gains can either be Short Term or Long Term in nature, depending on the period for which these assets are held.
- However, indexation benefit is available only for capital gains realized in Debt mutual funds.
- A holding period of 36 months or more is considered as long term for Debt Funds. (For Equity mutual funds, long term means a holding period of 12 months or more)
- Any holding period which is less than 36 months for Debt funds is treated as short term and the gains are added to the income of investor for tax calculation.
