No more long-term tax benefits for debt mutual funds: NRIs will be affected, here’s how

Dubai: In what was widely deemed as a historic move, India approved the removal of long-term tax benefits for debt funds. But isn’t this disappointing for NRIs investing in India? If so, what type of investments does this affect?

“The decision has stirred concerns in the fixed-income mutual fund industry that the measure would turn away investors,” said Dixit Jain, managing director at The Tax Experts DMCC, a Dubai-based tax advisory, while adding that the move was a “major blow to debt fund investors”.

One of the reasons why mutual funds have been popular among investors, both Indian residents and Non-Residents (NRIs), is its long-term tax benefits. Now it’s been decided that these investments will be taxed more. Let’s look at what this means to you.

Dixit Jain

As per a bill amendment proposed by the Indian government, a tax benefit that debt mutual funds currently enjoy will likely be taken away, Jain explained, as opposed to earlier when profits were subject to lower tax rate if the investments are sold three years from the date of investment.

Rupee Investment Transaction — Currently, investors in debt funds pay income tax on capital gains according to the income tax slab for a holding period of three years. Image Credit: Shutterstock

Debt mutual funds: How do they work, how to invest in them?

“Known also as ‘income funds’ or ‘bond funds’, debt mutual funds earn stable returns. Debt funds aim to generate returns for investors by investing their money in avenues like bonds and other fixed-income securities,” said Brody Dunn, an investment manager at a UAE-based asset advisory firm.

“This means these funds buy bonds and earn interest income on money. The yields that mutual fund investors receive is based on this. With debt mutual funds, not more than 35 per cent of pooled investor funds are invested in shares of domestic companies, with the majority amount put in bonds.”

Many investors opt for 50:50 allocation to stock and debt. Investors with higher tolerance for risk opt for 30 per cent to 40 per cent allocation to debt, with the rest in company stocks, which are comparatively much riskier. However, those with lower risk tolerance invest more in bonds.

How were debt mutual funds taxed up until now?

Currently, investors in debt funds pay income tax on capital gains according to the income tax slab for a holding period of three years. After three years these funds pay either 20 per cent with ‘indexation’ benefits or 10 per cent without ‘indexation’.

(What is ‘indexation’? It is a method used by investors to protect their earnings against tax erosion. The process allows them to adjust the cost of investment for inflation with the help of a price index. Indexation operates by taking into account the prevalence of inflation in the investment market.)

Stock-Savings — Known also as ‘income funds’ or ‘bond funds’, debt mutual funds earn stable returns. Image Credit: Shutterstock

“Earlier, the debt mutual fund were subject to long-term capital gains tax on debt mutual fund units if they are sold after three years from the date of investments,” added Jain. “Any sale of units before that period attracts a short-term capital gains tax.

“Now with this amendment, the debt mutual funds are considered at par with MLD (Market-Linked Debentures), and will be taxed as short term capital gains i.e. based on the slab rates irrespective of period of holding of such instrument.”

Glossary: Short-term capital gains vs Long-term capital gains

Profits you make from selling assets you've held for three years or less are called short-term capital gains. Alternatively, gains from assets you've held for longer than that are known as long-term capital gains.

But why did this new tax rule change come about?

The Indian Finance Ministry has defended the amendment, saying in a statement that an “arbitrage is being created where the interest income from some debt mutual funds are not getting distributed and is instead converted into long-term capital gains.

“Many taxpayers are able to reduce their tax liability through this arbitrage…. This is sought to be addressed.”

What is an ‘arbitrage’ in markets?

Arbitrage describes the act of buying a security in one market and simultaneously selling it in another market at a higher price, thereby enabling investors to profit from the temporary difference in cost per share. For example, gold may be traded on both New York and Tokyo stock exchanges.

As the amount of debt investment products managed in India stood at $151.04 billion, as of December 31, 2022, the size of the industry that will be affected by this tax tweak changes is significant.

Where will NRIs deposit in India now after this change?

Mutual funds provided liquidity to debt investors, and so the move is counter-productive if the amount is taxed higher than say fixed deposits in India. (The tax on FDs is 10 per cent if the interest amount for the entire financial year exceeds Rs40,000 (Dh1,800) for 2023-24.)

“If you are an debt investor, following the norm change, you will not only compare returns with other debt instruments, you may also look to shift your funds from mutual funds to bank fixed deposits,” said Jose Paul, an India-based banking analyst.

“If this holds true, such a shift could spur growth in bank deposits, which have been struggling to keep pace with the demand for credit over the past 12 months that led to a higher cost of funding for lenders.” Bank deposits grew 10.1 per cent last year, and could grow further with this new norm.