Government Scraps Long-Term Tax Benefits for Debt Funds

In March 2023, the Government scrapped long-term tax benefits for debt mutual funds with equity exposure of up to 35%. In this context, read this article and get an understanding of the new development pertaining to the Indian economy for the IAS exam.

Long-term Tax Benefits Scrapped for Debt Mutual Fund

The government has eliminated the advantageous long-term capital gains treatment (which includes indexation benefits), for income derived from debt mutual funds and other schemes that invest up to 35% in domestic company equity shares.

Existing system: Capital gains from the transfer of mutual fund units (other than equity-oriented funds) held for more than 3 years are considered long-term investments and taxes at 20% with indexation benefits.

Need for a reform:

• Currently, a situation is arising where the interest earned from debt mutual funds (where not more than 35% is invested in shares in domestic companies) is not paid out as income but instead is transformed into long-term capital gains taxed at a rate of 20% (with indexation), resulting in an arbitrage opportunity. Due to indexation, in some cases, it is brought down to even less than 10%.
• Many taxpayers are able to reduce their tax liability using this arbitrage and hence the tax provisions that were originally introduced in the 2023-24 Budget for market-linked debentures have now been extended to encompass debt funds by the government.

New system:

• The government will treat such returns as short-term and tax them at slab rate.
• The proposed move will equalize the taxation of mutual funds and bank deposits, affecting investments in such funds made on or after April 1, 2023.
• Though this move might hurt some mutual funds products, it will simplify the tax system.
• The primary focus of this proposed reform is on wealthy investors with significant assets and family offices who have benefited from taking advantage of tax loopholes in the current tax system.

Concerns and possible consequences:

• As these changes will also be applicable to gold funds, domestic fund of funds, and international funds which have an equity exposure of up to 35%, some experts believe that this move can have larger consequences.
• As a result of this reform, many investors may choose to shift their investments to bank fixed deposits, equity mutual funds, and hybrid funds that allocate more than 35% of their portfolios to equity and Sovereign Gold Bonds.

Government Scraps Long-Term Tax Benefits for Debt Funds:- Download PDF Here