Planning to Invest in Debt Mutual Fund? Learn About This New Tax Rule for Debt Funds

Individuals looking to invest in debt mutual funds have an interesting development coming their way. As per the new mutual fund regulations under the Finance Bill 2023, debt funds will now attract short-term capital gains from 1st April 2023.

As of now, debt mutual funds held for more than 3 years are treated as long-term investments and are eligible for long-term capital gains. However, with this new tax rule, the government has done away with the long-term tax benefits of debt funds if they invest less than 35% of their funds in equities.

 So, what does this new regulation imply, and how will it affect the debt investors? Let's find out.

What are debt funds?

Debt funds focus on generating fixed income for the debt investors,investing in securities like corporate bonds, government bonds, treasury bills, commercial papers, and other money market instruments. Since they are fixed-income instruments, they feature a fixed interest rate and pre-decided maturity.

This makes them a low-risk investment option as compared to equity funds. In fact, debt funds diversify their investment across various securities to bring this stability. And hence, they are an ideal investment for risk-averse investors, who can choose from various short-term debt funds and long-term debt funds.

New tax rule for debt funds

The amendment to Finance Bill 2023 has given birth to three categories of mutual funds for taxation-

1. Equity-oriented schemes with a minimum of 65% investments in equity

2. Mutual fund schemes with not more than 35% equity are to be treated as short-term capital gains

3. Schemes with more than 35% but less than 65% equity will be taxed at 20% and be eligible for indexation

As a result, under this new rule, debt mutual funds will be stripped of the long-term tax and cost indexation benefits. Instead, from 1st April 2023, debt mutual funds with 35% or less investment in equities will be treated as short-term capital gains and taxed as per the income tax slab of the investors.

However, all existing and new investments, till 31st March 2023, will continue to enjoy the lower long-term debt funds taxation at 20% and indexation benefits.

What are the existing mutual fund tax rules?

Currently, mutual fund investments are subject to taxation based on the investment duration. This means investment in long-term debt funds for more than three years is eligible for long-term capital gains tax at 20% with indexation benefits or 10% without indexation.

On the other hand, investment in short-term debt fundsfor less than three years features short-term tax gains and is subject to tax as per the investor's tax slab.

Whom will it affect?

The change will impact investors in the following ways-

1. According to financial experts, the proposal will bring bank FDs on par with debt mutual funds with the same tax implications, boosting bank FDs.

2. It can affect debt mutual fund investments in corporate bonds

3. Individual investors may shift from long-term debt mutual funds to other investment instruments, such as equity funds, non-convertible debentures, bank FDs, and other securities in the debt category.

4. The new mutual fund tax rule will not affect corporate or high-net-worth individuals (HNIs) who have invested in short-term debt mutual funds (less than three years)

Moreover, experts suggest going for long-term investments in debt mutual funds for higher capital appreciation.

Final Words

Apart from debt mutual funds, the new tax rules will affect various categories, including fold funds, hybrid funds, international funds, and domestic equity funds of funds (FoFs). So, if you're looking to allocate investments in these funds, doing so before 31^st March 2023 will help you get the tax benefits under the existing regime.

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