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Debt mutual funds still have tax benefits over bank FDs despite no LTCG indexation benefit

The Trade Book 141 May 24, 2023
From April 1, 2023, the rules of taxation for debt mutual funds have changed. According to the new tax rules, indexation benefits will not be available to "specified debt mutual funds" - where equity investments do not exceed 35% of their assets under management. These mutual funds will be taxed in the same manner as bank fixed deposits (FDs). Despite losing the long-term capital gain (LTCG) indexation benefit, debt mutual funds still offer certain tax benefits. These benefits can make debt mutual funds more attractive than bank fixed deposits.Here are the tax benefits that you need to know about.
Taxation only at the time of redemptionThough the tax treatment of debt mutual funds and bank fixed deposits have become similar, there is still a difference in the way they are taxed. This difference can give an edge to debt mutual funds over bank fixed deposits.

Usually, the interest earned from a bank FD is taxable every year irrespective of whether it is credited into the savings account concerned or not. This is especially true in case of cumulative bank FDs. Under such FDs, the interest is paid to the depositor at the end of the maturity period, but the interest accrued is taxed every year.

Do note that this can change depending on the taxation method followed by the individual. Mayur Shah, Tax Partner-People Advisory Services, EY, says, "The taxation of interest on bank fixed deposits will depend on the method of accounting (cash or accrued) followed by the taxpayer. However, practically, banks may deduct taxes at source from such interest every year."However, the same cannot be said for debt mutual funds. Suresh Surana, Founder, RSM India - a tax advisory and business consulting firm - says, "The tax incidence on debt mutual funds will only occur when they are redeemed or transferred to a different mutual fund scheme. Hence, no tax will be payable during the holding period of debt mutual funds." One can say that in debt mutual funds, the tax payable is deferred to a later date, he adds.Hence, an individual can avoid paying taxes till the debt mutual funds (MFs) are actually redeemed or switched to a different mutual fund scheme.Setting-off debt mutual funds gain with losses
Another tax advantage that debt mutual funds offer over bank FDs is the setting-off of losses. Once debt mutual fund's units are redeemed, the returns are earned in the form of capital gains. The income tax laws allow an individual to set-off capital gains against capital losses. Further, the capital losses can be carried forward to other financial years.The setting off and carrying forward of losses helps an individual to lower their taxable income. A lower taxable income leads to lower tax liability. Shah says, "Capital gains/loss from redemption, transfer or maturity of debt mutual funds shall be treated as a short-term capital gain/loss."However, there are certain rules that must be followed while setting off capital gains against losses and carrying forward of losses. Surana says, "The option of setting off and carrying forward of losses is available in the old and new tax regimes. The rules of setting off and carrying forward of losses are also the same in both the tax regimes."According to the income tax laws, short-term capital gains and losses from debt mutual funds can be set-off in the following manner:

If there is capital loss from debt mutual funds: The capital loss arising from debt mutual funds will be termed as short-term capital loss. Shah says, "Short-term capital loss from debt mutual funds is eligible to be set off against any LTCG or STCG arising during the same financial year in which the loss has occurred."

Say you have a capital loss of Rs 30,000 from debt mutual funds. Also, you have long-term capital gains of Rs 80,000 (after subtracting exempted Rs 1 lakh) from equity shares. By subtracting short-term capital loss from long-term capital gains, one's taxable income under the head "Income from capital gains" would be reduced. Going by this example, an individual will be liable to pay tax on Rs 50,000 (Rs 80,000 minus Rs 30,000) at the income tax rates applicable to such income.There may be cases where loss from debt mutual funds is higher than the total capital gains (both short and long term). In such cases, the individual is allowed to carry forward the capital losses. Surana says, "Income tax laws allow an individual to carry forward the short-term capital loss for a maximum of seven assessment years (eight financial years) if the loss amount cannot be entirely set off in one financial year. This carried forward short-term capital loss from debt mutual funds can be set off against both short- and long-term capital gains arising from any asset in future financial years."

If there is a capital gain from debt mutual funds: If there is a short-term capital gain from debt mutual funds, then such capital gains can be used to set off losses arising from other assets. Surana says, "Only short-term capital losses from other assets can be set off against short-term capital gains from debt mutual funds. In other words, if you have long-term capital losses from other assets, such losses cannot be set off against the short-term capital gains arising from debt mutual funds." Long-term capital losses can be set off against long-term capital gains.



What is the new tax rule for debt mutual funds from April 1, 2023The Union Budget 2023 has introduced Section 50AA in the Income Tax Act, 1961. According to this section, from FY 2023-24 (i.e., April 1, 2023), capital gains arising from sale or transfer of "specified mutual funds" shall be treated as short-term capital gains. These gains will be taxed at the income tax rates that are applicable to the taxpayer's income, irrespective of the holding period. Specified debt mutual funds are those where equity investments do not exceed 35% of their assets under management (AUM).Do note that these tax rules are applicable only on those debt mutual funds where an investment is made on or after April 1, 2023. If the investment is made on or before March 31, 2023, then LTCG indexation benefit is available.Apart from debt mutual funds, even gold mutual funds and international equity mutual funds (in both the mutual funds, domestic equity should be 35%or below) have lost the LTCG indexation tax benefit. The gains arising from these mutual fund schemes at the time of sale will also be short-term capital gains. These gains will be taxed at the income tax rates applicable on the individual's income.

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