From April 1, 2023 investors buying mutual funds with less than 35 per cent domestic equity exposure and holding them for over 3 years will no longer enjoy long-term capital gains treatment with indexation benefits.

This impacts schemes such as debt funds, international funds, target maturity funds, conservative hybrid funds, gold funds, select asset allocation funds and fund of funds. So, gains in such funds will be taxed at your slab/marginal rate and irrespective of period of holding, gains will be treated as short-term gains.

The use of indexation in computing gains aided in bringing down taxes as the impact of inflation was accounted for. Currently, investors pay tax according to their tax slab if the holding is less than 36 months (short-term).

For over three years, a 20 per cent tax was applicable with an indexation benefit or 10 per cent without an indexation benefit (long-term). Since the tax change will be effective from April 1, 2023, all previous investments will continue to enjoy indexation benefits on redemption.

Fresh investments done till March 31 will also be taxed under the old order. Note the tax change is relevant for investment tenures that are targeted for a period of holding of over 3 years. Short-term investments are unlikely to be impacted by any tax change.

Bigger blow for HNIs

Indexation benefit was more beneficial for those in the higher tax brackets. Out of a total AUM of ₹12.29-lakh crore as of end-December 2022, debt fund exposure of HNIs stood at ₹3.36-lakh crore while retail money in debt funds stood at only ₹33,125 crore. HNIs have suffered blows in the last two budgets on other counts too.

As per the 2023 budget announcement, income earned from all life insurance policies, excluding unit-linked insurance plans (ULIPs), with a premium of above ₹5 lakh will be taxable.

This is applicable for new policies, issued after April 1. This affects HNIs who made big-ticket life insurance investments. In Budget 2021, the government had announced that proceeds from ULIP shall be taxable if the annual premium exceeds ₹2.5 lakh in any year of the term of the policy, which also impacted HNIs.

This time though, retail investors have also had to face the music.

Pecking order change

This change in tax treatment for debt funds brings bank deposits, annuity products, and post office schemes such as FDs, SCSS and MIS on par with debt mutual funds. In the last 2 years, a slew of target maturity debt funds (TMFs) has been launched, riding on the Government Securities and State Development Loans.

Considering the favourable tax treatment, with rising bond yields, these products were marketed as an alternative to the traditional fixed-income products as they offered predictable returns and carried negligible risk if held till maturity.

Even otherwise, debt mutual funds of certain other categories too have been the go-to choice for senior citizens so far (for whom equity investments are considered riskier), given their tax efficiency over the traditional instruments and the need for positive real returns, which traditional instruments may sometimes not be able to provide.

With interest rates on FDs, etc. now having improved and debt funds losing the tax edge, investors have less of incentive to go for debt MFs.

Now, unless funds can make it up with higher returns, post-tax returns will be impacted going forward. Otherwise, debt fund investors may have to take more risk (by choosing to invest in the higher risk category of funds) to get more returns.

With taxation brought on par for MF vs other routes, RBI’s retail direct bond transaction platform may see interest from DIY investors, as some sophisticated investors can directly invest in G-Secs, without using the fund route, thus saving on expense ratios.

Since the tax treatment of gold funds is also on par with debt funds, Sovereign Gold Bonds (SGB) may also be more embraced now. Unlike other gold-related investments, in SGB you will receive an annual interest payment of 2.5 per cent, which adds to overall return.

While this interest payment is taxed at slab rates, there are no capital gain taxes if you hold the bonds till maturity, which is eight years. Comparatively, the long-term capital gain of gold ETFs (Exchange Traded Funds) will now be taxed at slab rates.

Overall, for investors in three categories of funds — debt, international and gold — this tax shock would mean having to revisit and fully rework their asset allocation decisions. Since post-tax returns now would be lower, they would have to invest higher sums to reach their goals.

Impact on fund-houses

The tax change is a body blow to fund houses. Debt funds (ex-liquid funds) constitute 19 per cent of the total AUMs of ₹40-lakh crore for the industry as of February 2023. These account for 11-14 per cent of revenues as per a CLSA report.

The immediate implication, especially from April 1, could be that debt funds see lower inflows as indexation benefit vanishes. Corporates through their treasury operations were the biggest investors in debt funds. Incremental flows could be under pressure.