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Debt Mutual  funds still work, even without indexation benefits

Inflows into debt funds persist despite the elimination of indexation benefits, a change that initially struck more as a psychological shock than an undeniable fact.

When the Finance Act of 2023 withdrew the indexation advantage in the taxation of debt mutual funds, it was initially perceived as a substantial setback. Whenever something we're accustomed to gets withdrawn, our initial response is typically adverse. However, with time, we adapt to the alterations.

The Finance Act explicitly mentioned that mutual fund schemes with less than a 35 percent allocation to equity—essentially, debt funds—and a handful of other fund categories would be subject to taxation as short-term capital gains, regardless of the holding duration. The dividend alternative for funds, known as the income distribution cum capital withdrawal choice, was already subject to taxation at the investor's marginal slab rate.

Starting from April 1 this year, the growth choice for debt funds became subject to taxation at the investor's marginal slab rate. Previously, for investments made until March 31 with a holding period exceeding three years in the growth option of a debt fund, the tax rate was 20 percent after factoring in indexation.

Indexation, in effect, substantially lowered the tax rate. Concerns arose that the removal of this tax advantage would negatively impact fresh investments in debt funds.

Debt funds in the customary categories, excluding Fixed Maturity Plans and Target Maturity Funds, managed assets worth Rs 12.3 lakh crore on February 28. The average assets managed in February amounted to Rs 13.03 lakh crore.

Comparatively, assets managed by debt funds stood at Rs 14.17 lakh crore on July 31, with the monthly average at Rs 14.56 lakh crore.

Before the tax changes, over 60 percent of the assets in debt funds were in portfolios with a maturity of up to one year. While there's no issue with holding a money market or very short-term maturity fund for an extended period, these funds aren't designed for a three-year holding.

There exist other debt fund categories with relatively longer portfolio maturities intended for investment horizons exceeding three years. The key point is that when the tax changes hit us, the impact was more psychological than a concrete fact. The bulk of the money was already invested in shorter maturity products.

Debt Investment Equivalence

From a tax perspective, debt mutual funds are now more or less on par with other fixed-income investment avenues. Interest earned on fixed (term) deposits is taxed as income from other sources at your marginal slab rate. Debt MFs are similarly taxed at the marginal slab rate, with a slight added benefit: you can offset short-term capital losses if you have any.

Direct bond coupons are subject to taxation at the marginal slab rate; any capital gains, if applicable, incur taxation at a comparatively lower rate. Taxation of portfolio management services is treated as a pass-through as if you held the securities directly and not through an investment vehicle.

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