A tax shock is coming the way of debt fund investors soon. Let's discuss how to deal with it.
24-Mar-2023 •Dhirendra Kumar
Shortly before it is to be passed, the Government has inserted an amendment into this year's budget that indexation will not be available for investments in debt funds, gold funds and some classes of hybrid mutual funds. Effectively, all those mutual funds with less than 35 per cent equity component will have no such thing as capital gains. No matter how long you hold them, when you sell them, the gains will just be added to your income in that year. Thus, it will be taxed at whatever income tax slab you are in.
This will greatly impact the tax you pay because indexation will no longer be available for calculating your gains. Note that indexation of capital gains is essentially inflation-adjustment. It is not a tax exemption nor a gift from the government. It is compensation for inflation, for the fact that the value of money degrades over time, and much of the so-called gains over the years are just an illusion. This illusion is created because today, money is inherently worth less than what it was worth when you invested. This degradation of money is, in any case, a side-effect of the action of governments. Any illusory gains that you get from inflation should not be taxed.
Inflation takes an enormous chunk out of your gains, and indexation just compensates for it. Let's take a real example. The current average three-year returns of medium-term debt funds, as listed on Value Research Online, are 6.56 per cent p.a., which is a total gain of 21 per cent over the period. If we look at the cost inflation index on the income tax department's website, we find that the index has increased from 289 to 331 over the period, a gain of 14 per cent. If we apply the index to our example funds, the real taxable gains are not 21 per cent but just 5.6 per cent. If indexation is not available, and you are in the top tax bracket, practically all your real gains will get taken away by the government. Part of your money will be eaten away by inflation, the rest taken away as tax.
What to do about it
Of course, the first thing to do is to wait and see the exact details after the change is notified. However, there are a few mitigation strategies that are there.
Debt funds: Vis-a-vis bank fixed deposits, debt funds still make more sense. There are two reasons for this. The biggest is that returns in debt funds accumulate and compound, while in FDs, they do not. In FDs, TDS on interest is charged every quarter and transferred out. In mutual funds, the tax is deferred till redemption. Thus, even if the rate of return is nominally the same, you earn more in a fund. The second reason is that there is better liquidity. You can redeem a debt fund at any time. With a deposit, you have to pay the penalty for withdrawal. For some types of deposits, an early withdrawal is not possible.
Tax-free alternatives: There are many such options for your fixed-beat needs - for example, PPF, EPF and NPS. Earlier, you may have bothered little, but now you must use these to the fullest extent possible.
Domestic funds with foreign equity: Apart from debt, international funds have also been affected by this change. However, since the law exempts all those funds with 35 per cent or more of domestic equity, you can shift to funds with domestic and international equity.
Gold bonds: If you were investing in gold funds, the logical choice is sovereign gold bonds or SGBs. You can find more details on SGBs here and here.
Of course, it would have been best if this change had not taken place, but now that it has, there are ways of dealing with it.