The Central Government in the Budget 2023-24, has removed the benefit of Indexation on Long Term Capital Gain (LTCG) which investors used to avail on debt funds and used to save taxes on their investment by adjusting it with inflation. In this post, we will understand the new taxation rule implemented in financial year 2023-24.
It is just to note that Indexation is a tax-saving technique used while calculating capital gains, which is especially useful in a high-inflation economy like India. This adjusts the purchase price of an investment to reflect the effect of inflation on it during the time you held it. This can reduce the amount of capital gains subject to tax, potentially reducing your tax bill. Indexation, a previously available tax benefit, aimed to address this concern for debt mutual funds.
Here is a simple example:
Suppose you bought a debt mutual fund in 2015 for ₹1,00,000 and sold it in 2023 for ₹2,00,000. The nominal capital gain is ₹1,00,000. However, inflation over these 8 years has reduced the value of money.
Suppose the government’s indexation coefficient for these years is 240 for 2015 and 320 for 2023.
The indexation formula is:
Indexed purchase price = (index value in the year the mutual fund was sold / index value in the year the mutual fund was purchased)
Indexed purchase price = (320 / 240) X 1,00,000 = ₹1,33,333
Now, calculate the inflation-adjusted capital gain
Adjusted capital gains=selling price−indexed purchase price
Adjusted capital gain= 2,00,000−1,33,333 = ₹66,667
So, by using indexation, your taxable capital gain reduces to ₹66,667 instead of ₹1,00,000. This reduces the amount of tax on your capital gains. Meaning now you will have to pay tax on ₹ 66,667.
This indexation benefit applies primarily to long term capital gains from debt mutual funds, and can significantly help in reducing the tax burden by taking into account the impact of inflation on investments.
Indexation was a powerful way to save tax when it comes to investing in debt mutual funds. This reduces your inflation benefits which impacts your returns by attracting heavy tax. But remember, you have to stay invested for at least 3 years to avail this benefit.
What are Debt Mutual Funds
Debt mutual funds allows you to invest in fixed-income instruments like government bonds, corporate bonds, and treasury bills. These instruments offer regular payments and work like Fixed Deposit which you can break any time. You can easily sell these instruments in the market to get your money.
This way you can maintain liquidity, if required any point of time in your life or business. They are generally considered less risky than equity investments. Debt funds cater to investors seeking a stable source of income and capital protection over the long term.
Types of Debt Funds Instruments:
1. Liquid Funds: Invest in ultra-short-term instruments like treasury bills and commercial papers, offering high liquidity and low volatility. Suitable for short-term surplus funds or emergency needs. They are generally less than 1 year investment options and are offered by Reserve Bank of India, whenever Government wants to raise some funds from the market.
2. Short-Term Debt Funds: Invest in debt instruments with maturities up to 3 years. They offer slightly higher returns than liquid funds while maintaining relatively low risk. Good for near-term financial goals like down payment for a car.
3. Income Funds: Invest in a mix of corporate and government bonds with varying maturities. They aim to provide regular interest income along with some capital appreciation. Suitable for investors seeking regular payouts alongside moderate growth potential. It includes Debentures which are debt instruments issued by corporate entities and are usually not backed by any collateral or physical assets. Whereas, Government Bonds are backed by the Government or Government institutions.
4. Government Securities (G-Secs): These are debt instruments issued by the Indian government to raise money. They come in various maturities, ranging from a few days (treasury bills) to 40 years (long-term government bonds). G-Secs are considered risk-free because they are backed by the sovereign guarantee of the Indian government.
To invest in Government Securities and Gold, you can search for Debt Mutual Funds which directly invest in these instruments and provide safe and better returns than Fixed Deposits and Savings Account.
You can choose any of the debt funds instruments as per your financial goals, and risk taking capacity. You can go for Debt Mutual Funds and help you in managing these instruments and also give regular payouts. The Government of India made changes in the investment made into Debt Mutual Funds and how a retail investor will be impacted, we will understand it here.
Big change in Finance Act 2023 on Indexation benefit
1. Removal of indexation benefit: From April 1, 2023, When figuring out long-term capital gains on debt mutual funds (debt-oriented), the indexation profit has been taken away. Any gain on these funds, whether it’s short-term capital gains (STCG) or long-term capital gains (LTCG), is now taxed as per income tax rate slab at which your salary is taxed. If you are taxed at 30% on STCG, it can impact you largely as it will lend you pay more tax to the Government.
2. Classification change: Debt Funds with Equity Exposure more than 35% (Balanced or Hybrid Funds): It will now be treated as short-term capital gains and will be taxed at the income tax slab rate of the investors. Whereas, LTCG (Long Term Capital Gain) taxation is similar to equity funds –
– Exempt from tax up to ₹1 lakh in a financial year.
– For LTCG exceeding ₹1 lakh, a flat rate of 10% tax applies (without indexation benefit).
Debt Funds with Equity Exposure <= 35% (less equity exposure): These funds are considered safer options within debt funds. LTCG on these funds enjoys the following benefits:
– Exempt from tax up to ₹1 lakh in a financial year.
– For LTCG exceeding ₹1 lakh, a flat rate of 20% tax applies.
Holding Period:
- STCG: Debt fund units sold within 3 years from the purchase date are considered STCG.
- LTCG: Debt fund units held for more than 3 years are considered LTCG.
Conclusion:
So now it will have a big impact on you as investor. This change might increase your tax liability on debt fund gains. However, you may consider these points:
- Debt mutual funds often offer attractive returns even without indexation.
- Diversification across various asset classes remains crucial for long-term financial goals.
- Explore alternative tax-saving options like PPF or ELSS mutual funds.
- Analyze the overall investment strategy and risk tolerance before making decisions.
But it is advised that you should not automatically stop yourself from investing because I always say, think long term in financial planning and build wealth.
Check our financial planning calculator
Key Points:
- The holding period to qualify for LTCG remains 3 years for all debt funds.
- STCG on debt funds is still taxed based on your income tax slab.
- LTCG taxation now depends on the fund’s equity exposure category. Safer debt funds (<= 35% equity) retain some LTCG benefits, while riskier debt funds (> 35% equity) are taxed similarly to equity funds.
