The Finance Act 2023 removed the benefit of Long Term Capital Gains (LTCG) tax for debt mutual funds. In the absence of clear communication from the Finance Ministry as to why this was done, several arguments have been put forth as justification for this change, but none of them stand the test of logic.
The most prominent explanation cited for the tax change is that it levels the playing field between fixed deposits (FDs) and debt funds. The logic is that since both these products earn interest income, there should be tax parity between them. However, it misses the point that debt funds and FDs are fundamentally different products. While debt funds are marketable investments, FDs are not. FD cannot be transferred, sold or bought from the existing holder of such deposit. They are clearly nontransferable and carry no market valuation risk. Debt funds are different as they are bought or sold at market prices. This market value may deviate significantly from the accrued book value of the debt fund’s assets, giving the investor the potential for capital gains and losses.
The earlier tax regime took cognizance of this fact by providing for both short term capital gains (STCG) and LTCG for such funds. Of course, STCG taxation for debt funds still exists, but only in name: it is similar to the taxation of interest income from FDs. The tax department is effectively saying that only the interest earned is included in the profit earned through debt funds. This is, at most, only partially true for certain categories of debt funds, such as liquid funds that focus on generating accrued interest income for their investors. Since their portfolio duration is very short, the effect of market interest rates on such funds is also less. However, this is not a given.
During the taper-tantrum in 2013, many liquid funds delivered negative overnight returns, and some even delivered negative weekly returns. During the same period, FDs remained unaffected. Thus, even liquid funds, a category of debt funds that come closest to FDs, carry market risk.
In case of medium to long term debt funds, capital gains and losses can be significant. For example, during 2020, when interest rates were falling, these funds delivered returns of over 10%, which was well above the yield-to-maturity (YTM) of their underlying bond portfolios. Capital gains contributed to returns exceeding YTM. Under the new tax regime, this capital gain will be penalized and taxed as earned income.
It is important to note that the above mentioned “excess return” is actually a compensation to the investor for taking on market risk. Such capital gains can very easily become capital losses. During 2022, when interest rates started rising, higher durations with many debt funds showed negative returns- some were over 10% underwater.
Debt funds carry significant interest rate risk which creates an equally significant certainty of earning capital gains or losses – a reality that the new tax regime ignores.
There are voices that product innovations in debt funds, such as target maturity funds, make them similar to FDs, hence the need for tax parity. However, the assets-under-management (AUM) under this category is roughly 10% of the total AUM of debt mutual funds and does not warrant the tax overhaul of all debt funds. In any case, while the replaceability of a liquid fund with an FD can also be debated, comparing the latter with a target maturity fund is far-fetched.
The tax change also creates a divergence between the taxation of debt funds and their underlying investment- direct bonds, which continue to receive LTCG taxation. Debt funds are a tax pass-through vehicle, and yet, the taxation of debt funds is now different from the taxation of the underlying bonds!
The point is that the tax changes were made to remove the tax arbitrage of debt funds over FDs, which are on a very volatile base. Presumably, there were external factors behind this tax change. Given the fragility of the banking sector in the developed world, tax changes may be a pre-emptive action to increase bank deposits. Or, perhaps we are unnecessarily building elaborate theories to justify tax change when the reason could be very simple – to raise additional tax revenue.
Ravi Saraogi is a SEBI Registered Investment Advisor (RIA) and co-founder of www.samasthiti.in.
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