Is the debt fund tax a big deal?

The new deal on the taxation of debt funds and some other types is a mixed bag. There's good news in the changes, and there's some bad news too. Or rather, there's neutral news and some bad news. I'm not saying good news because higher taxation on investment returns can never be good news for savers.

The neutral news is that even though there will be higher taxes, relatively few small individual investors will be affected, and that too to a small extent. The bad news is that this is a fundamentally unfair change that violates basic principles of fair taxation. Any retreat from fair taxation never stops at the first steps - it always gets worse over the years.

So what exactly has changed? Just before the passing of this year's budget on March 24, the government has included an amendment that eliminates indexation benefits for investments in debt funds, gold funds, and certain types of hybrid mutual funds. As a result, mutual funds with less than 35 per cent domestic equity component will not qualify for capital gains. Even if you hold them for an extended period, any gains will be treated as additional income in the year of sale and taxed according to your income tax bracket.

The tax payable on returns from these funds will be higher as the option for indexation to calculate your gains will be eliminated. It's important to note that the indexation of capital gains is simply a means of adjusting for inflation. It's not a form of tax exemption or a gift from the government. Instead, it's a way to compensate you for the fact that money loses value over time due to inflation, and much of the gains over a long period are illusory. Inflation causes money to be worth less than when it was originally invested, which is a side-effect of government actions. Therefore, it's unjust to tax any gains that are merely a result of inflation. That makes this tax unfair.

However, the impact will be marginal. According to what I'm told by AMFI and some industry executives, a total of Rs 4.5 lakh crore of AUM is in the funds that will be affected and are currently above three years of age. As a rough indicator, hypothetically assuming that this is the redemption point, projecting from 7.5 - 8 per cent returns a year, let's say that a quarter of this AUM is gains. Under the old system ending on March 31, 2023, the indexation benefit would reduce these 25 per cent gains to 12 per cent. On Rs 4.5 crore, that's a taxable amount of Rs 54,000 crore. At 20 per cent, the tax amount will be Rs Rs 10,800 crore. Under the new rules, without indexation, let us assume that the amount is a mix of investors in various tax slabs, and the weighted average tax percentage is also 20 per cent. This would mean that the taxable amount is Rs 1.13 lakh crore, and the tax is Rs 22,500 crore. That's proportionately a big difference, but the total amount is not that much when you think this is an indicative figure for the entire industry.

Another way of looking at the numbers is to see how much of the total industry AUM is held by individuals. That number is around Rs 2.25 lakh crore in all. Again, not a game changer by any means. So what should investors do about each of the types of funds? Vis-a-vis bank fixed deposits, debt funds still make more sense. There are two reasons for this, liquidity and compounding. In FDs, liquidity is worse, and tax is deducted every quarter. Thus, even if the rate of return is nominally the same, you earn more in a fund and can withdraw it at any point easily. There are also tax-free alternatives like PPF, EPF and NPS, which might suit you. As for international funds, I expect domestic funds with foreign equity will be more attractive as their taxation will be lower. That leaves only gold funds, where again, there is an interesting alternative in gold bonds.

All things considered, the actual impact on investors will be marginal and easily dealt with.

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