Need for Parity in Taxation

Context: Simplified tax regime for investments proposed in the July 2024 Budget has introduced  significant changes, particularly disadvantageous to investors in fixed income instruments. 

What are Capital Gains?

• Capital gain is the difference between the purchase price and the sale price of an investment. 
• Capital gains refer to an increase in the value of an investment over a specific timeframe.
  • If the NAV of a debt fund was Rs. 10 last year and today it stands at Rs. 15, the value of your investment has appreciated, and this is called capital gains. 
  • Here, your investment would yield a capital gain of Rs. 5 per unit on redeeming.

What is Indexation?

• Indexation is used to adjust the purchase price of an investment to reflect the effect of inflation on it. In this way, one will be able to lower your tax liability.
• A higher purchase price means lesser profits, which effectively means a lower tax.

Taxation and Indexation of Debt & Equity Funds: 

• For debt funds, which are long-term in nature (held for more than 36 months), capital gains are arrived at after indexing the purchase price of the investment.
  • Budget 2024 update: For debt mutual funds, the holding period to qualify as a long-term asset is now reduced from 36 months to 24 months.
• Unlikeequity funds, long-term capital gains on debt funds are taxable at the rate of 20% with the benefit of indexation.
  • Budget 2024 update: With effect from July 23 2024, long-term capital gains on debt funds are taxable at the rate of 12.5% without the benefit of indexation.
  • This means that investors can no longer adjust the purchase price of their investments for inflation, when calculating capital gains for tax purposes.
• Note: Indexation does not apply to equity funds. 

Current disparity in Taxation:

• The 2024 Budget removed indexation benefits on capital gains from debt fund investments made before April 1, 2023. This subjected all returns from investments to taxation at slab rates. 
• This change impacts not just debt-oriented mutual funds, but all fixed income investors, including those with bank deposits, corporate fixed deposits, small savings schemes, corporate bonds or government bonds.
• Taxing these returns at the slab rate has resulted in a negative real return to investors. 

Impacts of disparity in Taxation: 

• Skewed retail asset allocation:
  • Unfavourable tax treatment of returns on debt instruments versus equity capital gains has skewed retail asset allocation towards the risky stock market.
  • Savings in safer debt instruments are declining. 
  • The share of debt fund assets in the mutual fund industry has shrunk from 32% to 27% between December 2022 and December 2024.
  • Equity funds have seen their share increase from 58 to 61%. 
• Taxation influencing asset allocation:
  • Asset allocation decisions should ideally be based on the individual risk appetite of investors. But retail investors are shifting towards equity markets, due to removal of  indexation benefits on capital gains from debt fund investments.  
• Declining household savings:
  • Fixed income investments such as deposits and small savings schemes are primary investments for the majority of households. Negative real returns on these instruments take away the basic rationale for saving itself. 
  • Consequently, households’ savings in financial assets have been flat-lining in recent years, even as they are rising in gold and real estate assets.
• Adverse impacts on vulnerable sections:
  • Punitive taxation on fixed income instruments hits vulnerable sections of the population – be it the young earner parking money in recurring deposits or the retiree subsisting on passive income.
• Investment needs for Infrastructure:
  • Healthy household deposit flows are critical to our infrastructure building ambitions. 
  • These cannot take wing without retail participation in deposits, bonds and debt mutual funds. 

Way Forward

• The government must initiate corrective steps to lighten the tax burden on fixed income instruments. 
• Introduce a flat rate for fixed income instruments that allows for a positive real return. 
• Debt avenues favoured by vulnerable sections such as post office schemes and senior citizen deposits, must be exempted from tax.