Scrapping Tax Benefit for Debt Mutual Funds: Analysis

The Finance Bill 2023, passed by the Lok Sabha with 64 amendments, contains the controversial choice to remove the tax benefit for debt mutual funds. While the goal is to remove the advantage of debt funds over bank deposits, this decision will have far-reaching effects that need to be examined.

Investing in Mutual Funds

  • Investing choices made on behalf of investors: Mutual funds are financial vehicles that pool funds from numerous investors in order to purchase a diverse portfolio of stocks, bonds, or other securities. Mutual funds are administered by professional fund managers who make investment choices for the fund’s investors.
  • Diversified security portfolio: Mutual fund investors own a proportional share of the fund’s underlying assets, and the value of their investment rises or falls in response to changes in the value of the securities held by the fund. Mutual funds can provide investors with access to a diverse portfolio of securities, reducing the risk of investing in individual securities.

The main distinctions between mutual funds and loan mutual funds

  • Mutual funds and debt mutual funds are both types of investment funds, but they vary significantly.
  • Debate Over Eliminating the Tax Benefit for Debt Mutual Funds
  • The removal of the financial advantage for debt mutual funds: Last week, the Lok Sabha approved the Finance Bill 2023 by voice vote, with 64 amendments, including the elimination of the tax break for debt mutual funds.
  • What it means: As a result of this shift, investors in debt mutual funds will no longer be able to use indexation to calculate long-term capital gains. Such investments will now be taxed at the income tax rates relevant to an individual’s tax bracket beginning April 1.
  • Motive: The goal of this action is to eliminate the edge that such debt funds have over bank deposits. However, the implications of this choice must be carefully considered.

The Effect of Losing a Tax Break

  • Effect on the movement of funds: The elimination of the tax advantage will cause investors to reconsider their allocations to debt mutual funds, potentially affecting flows into these funds.
  • influence on the bond market: Because debt mutual funds channel funds into the bond market, this may have an influence on the growth and development of the bond market in India.
  • For example, according to a Crisil study, institutional investors account for 70% of debt fund investment, while individual investors, including high net worth individuals, account for 27% as of December 2022.
  • Impact on corporate debt: This rule change may cause a shift in investments away from debt mutual funds and towards other instruments, which may influence flows to the corporate bond market and demand for corporate debt.

The Importance of Rationalization

  • There is a need to distinguish between bank deposits and debt funds because bank deposits are insured up to Rs 5 lakh while debt mutual funds bear risk based on the risk profile of the bonds they hold.
  • It has been suggested that India’s capital gains architecture should be reexamined and reconfigured.
  • Not only are there various tax rates for different asset classes, but the holding period for distinguishing between short- and long-term capital gains also differs by asset. As a result, rationalisation of the tax rate and/or the holding period is preferable.

@the end

While the elimination of the tax benefit for debt mutual funds may reduce their advantage over bank deposits, the long-term consequences must be closely examined. There is a need to recognise the finer aspects of distinction between bank deposits and debt funds, as well as to rationalise India’s tax architecture. As a result, broader discussions and debates on these topics are required.

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