Changes in taxation of non-equity funds from FY 23-24

Many of us choose to invest in debt funds for a lower tax rate than FD, but from 1 Apr 2023 onwards, the benefit of lower tax is no more applicable to new investments. As per recent change, Non-equity oriented funds (Funds where equity investment does not exceed 35% of the total portfolio value) gain will be added to an investor's income and taxed as per the income slab. Let's understand this change and its impact on related instruments.

Until FY22-23, debt funds taxation depends on the investments' holding period. If you hold the funds for over three years, gains were qualified as long-term capital gain (LTCG) and are taxed at 20% with indexation. Indexation is the adjustment done in the purchase price as per the inflation rate, and investors benefit from reduced tax liability. To define this benefit, government declare the CII (Cost of Inflation Index) number every year and one can get the inflation-adjusted purchase price from the following formula. This purchase price is used to calculate the capital gain and taxed accordingly.

Inflation-adjusted purchase price = CII of sale year*Purchase price / CII of purchase year

Following is the CII number of the previous year.

Source: incometaxindia.gov.in

If You purchased the fund at a NAV of Rs. 100 on 1 Apr 2019 (FY 2019-20) and sold at Rs. 130 on 10 Apr 2022(FY 22-23), your purchased cost will be 331*100/289 = 114.5 and your capital gain will be 130 – 114.5 = 15.5 and you need to pay 20% on this capital gain.

For holding the funds for less than three years, gains were qualified as Short term capital gain (STCG), added to an investor's income, and taxed as per the slab rate.

What has changed now?

As per the notification from Ministry of Finance, there is no short-term and long-term capital gain on fresh investments in debt funds (where equity holding does not exceed 35%). However, investments done until 31 Mar 2023 will continue to be taxed as per the old rates. With these new changes, all debt funds gain will be added to an investor's income and taxed as per the income slab, irrespective of the holding period. This brings the tax treatment of FD and debt funds at par and debt funds no more have any tax advantages.

Does this only impact debt funds?

No, it will also impact all other types of funds where equity investments are less than 35%, i.e. Gold ETFs, FOF, International funds, etc. Now all these instruments are taxed as per the income slab of an investor.

Till now, these funds have also been taxed as per the debt funds tax rates only.

Takeaway

Let's see how the investment landscape has changed because of these regulations and how other comparative instruments fare with each other.

Better liquidity

As per recent changes, Debt funds taxation is at par with fixed deposits and there are no tax advantages. However, one can choose a debt fund for superior liquidity. Also, open-ended debt funds don't have a lock-in period like some FDs have; investors can redeem debt funds at their convenience.

Advantage of tax deferment

Debt fund investors can defer their tax liability until they book their capital gains. Please note that FD tax needs to be paid on an accrual basis, i.e. whenever interest is added to your FD account.

Returns

FD offers fixed returns for a defined period. Debt investors may take advantage of interest rate cycles to reap better returns. This can be done by choosing the right duration fund as per the cycle.

The better option for Gold : GOLD ETF is no longer a preferred option from a tax-saving point of view. Even physical gold remains a good option as it still enjoys the old rate where indexation benefit is available if it is held for more than three years. However, the tax treatment is the same for a holding period of less than three years. Also, one needs to pay applicable GST and making charges for physical gold. Sovereign Gold Bonds (SGB) are the best choice for gold investment as you will earn a 2.5% p.a. extra return and no capital gain tax if held till maturity. However, SGB has poor liquidity if one wants to redeem before maturity.