Amendments to taxation rules regarding debt funds included in the Finance Bill 2023 have delivered an unexpected blow to mutual fund investors. Inflation indexation benefit granted to long-term investors in debt mutual funds has been done away with and returns will be taxed as short-term capital gains. Such tax treatment brings debt funds on a par with fixed deposits and small savings schemes.

The move may redirect some of the future debt fund flows towards bank fixed deposits, taking the sheen off popular categories such as target maturity funds, Bharat Bond ETFs and fixed maturity plans which were a hit with investors in higher tax brackets. Finance Ministry officials have justified the change as plugging a loophole that allowed debt mutual funds to convert the interest income on bonds into capital gains. While it may be justified from a revenue viewpoint, the Centre should do a holistic assessment of capital gains taxes, including other priorities in it such as directing capital to preferred avenues and building up different market segments. Also, the change now should ideally have been made in the Budget as it would have allowed greater public discussion and feedback from the MF industry.

This move, along with the Budget proposal to tax proceeds of high-value insurance plans, clearly signals the Centre’s intent to close all opportunities for tax arbitrage wherever it unearths them. It is about time that the BFSI industry acknowledged this reality and designed products that appeal on their own merits, instead of leaning on the crutches of tax arbitrage. While corporate treasuries will be unaffected by the change now, high net worth investors in long-term debt funds could bear the brunt, which is probably the intent too. As of February 2023, long term debt funds held about ₹7.8-lakh crore of the ₹40-lakh crore assets managed by domestic mutual funds, with ₹3.3-lakh crore contributed by individual investors. Flows into these funds could now dry up, weighing on debt market activity. Mutual funds are among the most active participants in the bond market, accounting for about 16 per cent of corporate bond financing, about 10 per cent of NBFC financing and over 80 per cent of commercial paper subscriptions.

HNI investors may now explore direct investments in listed NCDs (where long-term gains are taxed at 10 per cent) and corporate FDs but smaller retail investors could find this switch difficult given accessibility and liquidity issues. This tax change could also have the effect of nudging retail investors in higher tax brackets, back from financial to physical assets. While indexation benefits have now been removed for all financial assets, physical assets such as real estate and gold continue to enjoy them. If simplifying the tax regime is the Centre’s intent, it would do well to refrain from such piecemeal changes and usher in a uniform tax treatment for income, short and long-term capital gains that holds good for all instruments and assets.