June 10, 2023

There is an uproar in the Indian investing community over the collapsing of the long- and short-term tax status of debt funds, removing the indexation benefit from financial year 2023-24 and the manner in which it was pushed through. In what looks to be a hasty, non-debated move, finance minister Nirmala Sitharaman’s fifth budget passed, along with an amendment that set of a series of detonations across the Indian market-linked investing community. While tax changes are par for the course, it is the sheer absurdity of this move that has left people scratching their heads. Amendment 20 takes away the long-term tax rate of 20% with indexation and collapses it with the short-term rate for debt mutual funds that invest no more than 35% of their assets in domestic equity. This definition will therefore include some other categories such as gold, international funds and fund of funds. The total AUM affected is over 20 trillion as of December 2022. The erstwhile long-term gains will now get added to income and be taxed at income slab rate.

Bid to remove tax benefit from debt funds is hasty

There are two problems with this. One, this move ignores the basic tenet that market-linked products carry risk and are therefore must be taxed differently than fixed-return products such as bank deposits. Two, the government’s own desire to gather retail funds for the borrowings of state-owned companies using bond index funds is now going to be far less attractive than before. Instead of solving the problem of the differential capital gains tax treatment of various asset classes at one go, this move has ended up sending a shock wave through markets.

First, let’s understand the difference between interest and capital gain. A bank deposit or a bond held to maturity generates interest that is either paid out regularly or at maturity. This, under Indian tax law, is added to income and the tax applicable becomes your highest slab rate – also called your marginal tax rate. Capital gains arise when there is a difference between the buying and selling price and you are taxed on the profit. This profit is taxed depending on the time that you held this asset. Short term taxes are usually the same as the marginal income tax rate and long-term rates (to encourage investors to stay) are lower.

Here begins the problem. There is no parity in both the time duration that makes an asset short or long term or in the rates. For example, equity goes long term at just one year of holding, real estate at two years and debt and gold at three years. The rates are different too. Long term real estate is taxed at 20% with indexation, equity at 10% without indexation. Debt funds and gold at 20% with indexation.

Indexation is when the taxman allows investors to factor inflation in the buying price of the asset, that reduces the profit and therefore the tax. A property bought 10 years ago at 1 crore, for example, and sold at 2 crore in FY23, will not be taxed on 1 crore of profit. The buying price will be ‘adjusted’ for inflation and will be 1.66 crore, reducing profit to 34 lakh. Lower profit will mean a lower tax. Debt funds were getting this benefit if held for at least three years, but now after the amendment, for investments made from 1 April 2023, this tax rule is gone. The entire redemption amount will be added to income and taxed at slab rate, no matter how long you hold a bond fund.

Why did the government do this? A note from the Ministry of Finance says that the aim is to remove the arbitrage “where interest income from debt mutual fund (where not more than 35% invested in share in domestic company) is not distributed and converted into long term capital gains of 20% (with indexation). In some case it comes to even less than 10% due to indexation. Thus, many taxpayers are able to reduce their tax liability through this arbitrage. This is sought to be addressed.”

I find the logic flawed because a debt fund is a market-linked product that is marked-to-market every day. This means that investors take on the risk of market events including interest rate changes (rising interest rates cause bond prices to fall resulting in a fall in the NAV of debt funds ), credit risk (the risk of bonds losing their credit ratings and causing bond prices to fall) and liquidity risk or the risk of not getting your money back as the mutual fund cannot sell its assets since the markets have frozen due to a global or national calamity. By treating a bank deposit and a market-linked product at par in terms of taxation, the risk taken by the debt fund investor has not been rewarded in terms of a lower tax rate. In addition, what happens when the investor makes a loss on her debt funds? Will she get a set-off against capital gains elsewhere?

Longer tenor debt funds in India were just about beginning to see a trickle of investor interest due to changes in the way the asset class is regulated with investor holding period being matched to the average maturity of the bond portfolio. The risk is now much better monitored and reported on a monthly basis through a dynamic risk-o-meter (https://www.amfiindia.com/investor-corner/online-center/riskmeterinformation).

The change is also going to affect the government’s own attempts to gather retail funds for public sector units using the Bharat Bond route that allows for investors to buy a PSU bond index fund at a very small cost. Non-bank finance companies that were big borrowers from debt funds will get affected as well. Why did the government do this? It could be lobbying pressure from the banking and insurance industry to reign in the growing popularity of longer tenor debt funds that were beginning to give the competition.

Tax changes that affect markets need far deeper thought and consultations before they are announced. Ideally, the entire capital gains story should have been rewritten keeping some basic ground rules of finance in mind. The amendment that has been pushed through is a very poor market signal to a risk-averse investing public that was just about getting ready to dip a toe in the market-linked debt market. The government should review this in the interest of markets, investors and first-principle based policy making.

(Monika Halan is the author of the bestselling book Let’s Talk Money)

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