The Finance Act of 2023 removed the indexation advantage from debt mutual funds. It says that profits from funds having an equity proportion of less than 35% will be taxable as short-term capital gains (STCG), regardless of holding duration. Non-equity fund STCG is taxed at their respective slab rate. It is 30% plus surcharge and cess if you fall under the highest tax bracket. It basically implies that the indexation advantage, which was applicable for a three-year holding period, is now no longer available.
The rate of taxation of equity funds stays unchanged. Gains from equity mutual funds held in the growth category for more than a year will be treated as long-term capital gains (LTCG) and taxable at 10% (plus surcharge and cess). Equity funds are taxed at 15% if held for less than one year. Hence the Finance Act 2023 made adjustments to taxes from gains in mutual fund, creating a third type of fund for taxable purposes.
New Mutual Fund category taxation:
The Finance Act of 2023 refers to funds with less than a 35% exposure to domestic equity will not have indexation advantage. That is, the profits from funds having an equity proportion of less than 35% shall be taxed as STCG, regardless of holding term. Thus, it covers debt funds, gold funds, overseas equity funds, and any other mutual fund with an equity proportion of less than 35%. Now, we must understand what we recognize as debt funds, as specified in the Finance Act of 2023.
Till now, the two current tax types were equity and debt. With the changes brought by the Finance Act, there comes the new taxation type, which includes funds with equity allocations ranging from 35 to 65 percent of the portfolio. Funds having more than 65% exposure to domestic equities are taxed as equity funds, whereas those with less than 35% equity exposure are taxable as debt funds. But for the funds in the mid-bracket of 35% to 65%, as the percentage allocated to equity is less than 65 percent, the taxes is the same as it is for non-equity. However, because indexation continues to be available, those mutual funds in the range of 35% to 65% equity allocation, still profit from indexation.
So how does Indexation work for these funds in the range of 35% to 65% equity allocation?
The first requirement is that – you must make investments in the fund’s growth plan and stay invested for a minimum of three years. Each year, the tax administration releases a Cost Inflation Index (CII). The profits from mutual fund investments become taxable when you eventually redeem your units, which are regarded as a sale, for the purpose of taxation. In addition, your purchase price is ‘indexed up’ using the CII of the year of selling divided by the CII of the buying year.
Let us look at this indexation benefit with an example. Assume you invested in this mid-bracket mutual fund with a Net Asset Value (NAV) of 100 in February 2020. When you redeem the units from this debt fund investment in July 2023, you are entitled for indexation, as you have redeemed the units after a three-year holding period. Assume the NAV of this mutual fund at the time of redemption in July 2023 is 130. The CII for your investment year (2019-20) was 289, while the CII for your redemption year (2023-24) was 348.
As a result, your purchase price is indexed up to 348/289X10= 12.04. Hence, after indexation, the taxable element of your gain is 30 minus 12.04, which is 17.96. As a result, the tax rate is not applicable on the absolute gain of 30 (130 minus 100).
Using a 20% taxation rate (omitting the surcharge and cess for ease of calculations), the tax amount is 3.59 (which is 20% of 17.96). In practice, the tax payment of 3.59 on a gain of 30 rupees is on the lower side (as compared to tax amount of 6.00, without the indexation benefit).
Which funds are eligible for indexation in this mid-bracket?
The main question at this point is; which funds fit into this mid-tier and are qualified for this indexation benefit? As you may expect, hybrid funds are the most probable choices.
Debt funds are unable to include as much equity as equity funds, and equity funds must have more than 65% equity. However, with these hybrid funds as well, it is not viable to manage the funds funds with equity allocations ranging from 35 to 65 percent. This is because – all fund categories are defined under the Securities and Exchange Board of India (SEBI) categorization guidelines.
Currently, only a few AMCs have allocated 35-65% of their multi-asset funds (MAF) towards domestic equity. According to SEBI’s guidelines for MAF, investment into at least three kinds of assets (for example, stock, debt, gold, or any other) and investment of at least 10% in every class of asset is required. As a result, mutual fund companies need to specify the range of equity investment.
However, before investing in a MAF, verify with the mutual fund company to see if it offers indexation benefits. For instance, if the fund is 70% equity, it is considered an equity fund for tax reasons and is not qualified for indexation benefit.
Restrictions on the funds:
Due to SEBI restrictions, hybrid categories cannot be structured in the 35-65 percent equity range.
Conservative hybrid mutual funds deploy no more than 25% of their assets in equities. The required minimum equity exposure in aggressive hybrid funds, arbitrage funds, and equity savings funds is 65%. This results in just Balanced Advantage Funds (BAF) left out in the mid-bracket range, which are typically managed as equity funds. It is theoretically feasible to adjust the BAF for indexation advantage, but an AMC will only do so if the vast majority of investors want it. Investors generally favour equity taxation and the rationale for this is that tax effectiveness is attainable after one year of holding (10% vs your applicable tax slab rate), whereas indexation advantage requires three years holding period.
Final words:
The level of indexation, which is carried out by taking into account the cost inflation index, determines the tax effectiveness during a holding period of more than three years. In most years, indexation results in a tax percentage that is less than 10% of the gains, which is advantageous to you. If you have a longer time horizon for your non-equity fund investments and would prefer indexation, you should look into suitable multi-asset funds. But keep in mind that taxing is only one factor to consider; your fund selection must be dependent on your financial goals and appropriateness.
