Debt Mutual Fund Taxation

The tax rate on debt funds is determined by the investor's income tax slab. The short-term capital gains tax rate is 20% and for the long-term capital gains, the tax rate is now a flat 12.5%, but without any indexation benefits.
EXPLORE FUNDS
Taxation on Debt Mutual Funds
EXPLORE FUNDS
3 min
24-September-2024

Debt mutual funds are classified based on their underlying investments. To qualify as a debt fund, a fund must hold at least 65% of its portfolio in bonds or money market instruments. Debt funds of funds invest primarily in other debt funds. The tax implications for debt funds depend on the holding period. For funds purchased before April 1, 2023, short-term (up to 36 months) gains are taxed at the investor's ordinary income tax rate, while long-term gains are taxed at a concessional rate. However, after April 1, 2023, all debt fund gains, regardless of holding period, are treated as short-term and taxed at the ordinary income tax rate. This change simplifies tax treatment but may impact long-term investment strategies.

In this article, we examine what a debt mutual fund is, the types of income it offers and how to compute the tax on debt mutual funds.

What is a debt mutual fund?

A debt mutual fund is a type of mutual fund that invests primarily in debt instruments like government bonds, corporate bonds, treasury bills and other fixed-income securities. Since these instruments offer returns at a predetermined rate, the risks associated with them are comparatively lower than the risks of market-linked assets. So, debt funds are ideal for conservative investors who want to minimise market risks.

Types of returns from debt mutual funds

To understand the nuances of debt funds taxation, you need to first check out the different types of returns you can earn from these mutual fund schemes. Typically, debt funds offer the following types of returns or earnings.

  • Dividends: Instead of reinvesting the profits they make, debt funds may pay out a part of these gains to the investor as dividends. For instance, say you hold 2,000 units in a debt fund that pays Rs. 3 per unit as dividends. So, you will receive Rs. 6,000 as dividends from the fund.
  • Capital gains: Capital gains are profits that you earn when you redeem your debt mutual fund holdings. If the NAV of the units at the time of redemption is higher than the NAV at the time of purchase, you earn profits that are taxed as capital gains. It is here that indexation was once an important aspect to consider.

Now that you know the different types of income you can earn from debt funds, let us discuss the tax on debt mutual funds in each case.

Debt funds taxation - How are dividends from debt funds taxed?

Before March 31, 2020, dividends from debt funds were tax-free in the hands of investors because the Asset Management Company (AMC) or the fund house paid Dividend Distribution Tax (DDT) on these sums. However, since the DDT was abolished in Budget 2020, dividends are now added to the total income of investors and taxed as per the applicable slab rate.

So, say you earn Rs. 7,000 as dividends from your debt fund investments and your income is taxable as per the 30% slab. This means the dividends will also be taxed at the same rate.

Explore these essential articles on income tax for comprehensive insights

  1. Income Tax Slabs for FY 24-25
  2. Income tax return extended date for AY 2024-25
  3. Section 112A of Income Tax Act
  4. Section 111A of Income Tax Act
  5. Section 56 of Income Tax Act

Debt funds taxation - How are capital gains from debt funds taxed?

Before April 1, 2023, capital gains from debt funds were classified as long-term or short-term gains based on the period over which the units were held before the sale. The classification and tax on debt mutual funds before April 1, 2023, was as follows:

Type of capital gain Period of holding debt fund units before the sale Tax on capital gains
Short-Term Capital Gains (STCG) Up to 36 months Taxed at the applicable income tax slab rate
Long-Term Capital Gains (LTCG) Longer than 36 months Taxed at 20% with the benefit of indexation


However, Finance Minister Ms. Nirmala Sitharaman announced several changes to how capital gains will be taxed while presenting the Union Budget 2024. One of the changes is how the holding period is defined for debt funds. For instance, the short-term capital gains (STCG) tax post-Budget 2024 applies to debt funds that are held for less than 24 months, while the long-term capital gains (LTCG) tax applies to those with a holding period greater than 24 months (for debt funds purchased before April 1, 2023).

Here is a quick snapshot of the changes and how debt funds will be taxed following the Union Budget 2024 announcement.

Short-term capital gains (STCG):

Asset

Holding period

Tax on capital gains

Debt funds purchased before April 1, 2023

Up to 24 months

According to the investor’s slab rates

Debt funds purchased after April 1, 2023

Always short-term

According to the investor’s slab rates

 

Long-term capital gains (LTCG):

Asset

Holding period

Tax on capital gains

Debt funds purchased before April 1, 2023

Greater than 24 months

12.5% without indexation benefit

Debt funds purchased after April 1, 2023

Always short-term

According to the investor’s slab rates

 

Decoding the meaning of indexation in debt funds taxation

Indexation is the process of adjusting the investment amount or purchase price to account for inflation. In this process, the cost of acquisition is adjusted or indexed using the relevant Cost Inflation Index (CII) before the tax on debt mutual funds is calculated.

Check out the formula for computing the indexed cost of acquisition:

Indexed cost of acquisition = (CII of the year of sale ÷ CII of the year of purchase) x (Cost of acquisition)


For example, say you invested Rs. 1 lakh in a debt mutual fund on April 1, 2012 and sold your investments for Rs. 7 lakh on April 1, 2018. Since the holding period is more than 36 months and the units were redeemed before April 1, 2023, the benefit of indexation applies. So, the indexed cost of acquisition will be calculated as shown below:

Indexed purchase cost:

= (CII of the year of sale ÷ CII of the year of purchase) x (Cost of acquisition)

= (CII of FY19 ÷ CII of FY13) x Purchase price

= (280 ÷ 200) x Rs. 1,00,000

= Rs. 1,40,000

The LTCG will be the difference between the sale value and the indexed purchase price, which is Rs. 5,60,000 (i.e. Rs. 7 lakh — Rs. 1.4 lakh). This sum is taxed at 20%.

No indexation benefit for LTCG on debt mutual funds invested before April 1, 2023

It is worth mentioning that from April 1, 2023, the government removed the indexation benefit for debt mutual funds. Any capital gains arising from selling these funds are now taxed at the investor's income tax rate, regardless of how long they were held. Before this change, if the funds were held for more than three years, they were considered long-term capital gains (LTCG) and taxed at 20% with the indexation benefit.

Moving forward to new amendments, in the July 2024 budget, the government introduced a new LTCG tax rate of 12.5% for all assets, whether listed or unlisted. However, debt mutual funds were excluded from this new regime. Capital gains from debt mutual funds will continue to be taxed at the investor's income tax slab rate without any indexation benefit. This creates a situation where debt mutual funds are treated differently from other assets when it comes to taxation.

Now, the question arises: what would happen if you invested in debt mutual funds on or before April 1, 2023 and sold them on or after July 23, 2024? In this case, any long-term capital gain (LTCG) will be taxed at 12.5% without any benefit of indexation.

List of debt mutual funds in India

Understanding debt mutual fund taxes after 1st April 2023

While the example above explains how indexation for debt funds taxation works, Budget 2023 brought in an amendment that does away with the need for indexation altogether. With effect from April 1, 2023, all capital gains from the sale of debt mutual funds are classified as short-term capital gains and taxed at the income tax slab rate applicable to the investor.

This means that in the above example, if you had redeemed your investments on April 10, 2023, the STCG from the transfer would be Rs. 6 lakh (i.e. Rs. 7 lakh — Rs. 1 lakh). This STCG will be added to your income and taxed at the income tax slab rate that applies to you.

Mutual fund taxation - STCG rates, holding period on various mutual fund schemes

Asset Type

Earlier Rules

New Rules After Budget 2024

Equity mutual funds

Holding Period: Up to 12 months, STCG: 15%

Holding Period: Up to 12 months, STCG: 20%

Debt mutual funds purchased before April 1, 2023

Holding Period: Up to 36 months, STCG: Slab rates

Holding Period: Up to 24 months, STCG: Slab rates

Debt mutual funds purchased after April 1, 2023

Holding Period: Always short-term, STCG: Slab rates

Holding Period: Always short-term, STCG: Slab rates

Domestic equity ETFs

Holding Period: Up to 12 months, STCG: 15%

Holding Period: Up to 12 months, STCG: 20%

International equity ETFs (listed in India) before April 1, 2023

Holding Period: Up to 36 months, STCG: Slab rates

Holding Period: Up to 12 months, STCG: Slab rates

International equity ETFs (listed in India) after April 1, 2023

Holding Period: Up to 36 months, STCG: Slab rates

Holding Period: Up to 24 months, STCG: Slab rates

International equity ETFs (listed outside India)

Holding Period: Up to 36 months, STCG: Slab rates

Holding Period: Up to 24 months, STCG: Slab rates

Domestic debt ETFs purchased before April 1, 2023

Holding Period: Up to 36 months, STCG: Slab rates

Holding Period: Up to 24 months, STCG: Slab rates

Domestic debt ETFs purchased after April 1, 2023

Holding Period: Always short-term, STCG: Slab rates

Holding Period: Always short-term, STCG: Slab rates

International debt ETFs purchased before April 1, 2023

Holding Period: Up to 36 months, STCG: Slab rates

Holding Period: Up to 24 months, STCG: Slab rates

International debt ETFs purchased after April 1, 2023

Holding Period: Always short-term, STCG: Slab rates

Holding Period: Always short-term, STCG: Slab rates

All fund of funds

 

 

Equity-oriented (invests minimum 90% in equity-oriented fund and such equity-oriented fund also invests 90% of proceeds in listed equity shares in India)

Holding Period: Up to 12 months, STCG: 15%

Holding Period: Up to 12 months, STCG: 20%

Other funds purchased before April 1, 2023 (less than 65% in debt)

Holding Period: Up to 36 months, STCG: Slab rates

Holding Period: Up to 24 months, STCG: Slab rates

Other funds purchased after April 1, 2023 (less than 65% in debt)

Holding Period: Always short-term, STCG: Slab rates

Holding Period: Always short-term, STCG: Slab rates

International fund of funds

Holding Period: Up to 36 months, STCG: Slab rates

Holding Period: Up to 24 months, STCG: Slab rates

Gold mutual fund before April 1, 2023

Holding Period: Up to 36 months, STCG: Slab rates

Holding Period: Up to 24 months, STCG: Slab rates

Gold mutual fund after April 1, 2023

Holding Period: Always short-term, STCG: Slab rates

Holding Period: Up to 24 months, STCG: Slab rates

Gold ETFs before April 1, 2023

Holding Period: Up to 36 months, STCG: Slab rates

Holding Period: Up to 24 months, STCG: Slab rates

Gold ETFs after April 1, 2023

Holding Period: Always short-term, STCG: Slab rates

Holding Period: Up to 24 months, STCG: Slab rates

Dynamic/Multi-asset allocation funds

 

 

Aggressive hybrid fund

Holding Period: Up to 12 months, STCG: 15%

Holding Period: Up to 12 months, STCG: 20%

Balanced hybrid fund

Holding Period: Up to 36 months, STCG: Slab rates

Holding Period: Up to 24 months, STCG: Slab rates

Conservative hybrid fund (purchased before April 1, 2023)

Holding Period: Up to 36 months, STCG: Slab rates

Holding Period: Up to 24 months, STCG: Slab rates

Conservative hybrid fund (purchased after April 1, 2023)

Holding Period: Always short-term, STCG: Slab rates

Holding Period: Always short-term, STCG: Slab rates

 

Conclusion

This sums up the nuances of the indexation benefit in debt mutual funds and also explains the current regulations for debt funds taxation. If you want to make a lump sum investment or start a SIP in debt funds hereafter, keep the tax principles in mind and plan your purchases and redemptions accordingly.

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Frequently asked questions

What changes were made to the taxation of debt mutual funds after April 1, 2023?

After April 1, 2023, the indexation benefit for calculating long-term capital gains (LTCG) on debt mutual funds was removed. Now, regardless of how long you hold the debt mutual funds, any LTCG is taxed at your applicable income tax slab rate. Before this amendment, the LTCG was taxed at 20% with indexation benefits.

How are capital gains from debt mutual funds taxed for investments made before April 1, 2023?

If you invested in debt mutual funds before April 1, 2023, and held them for more than three years, the arising long-term capital gains (LTCG) were previously taxed at 20% with indexation. However, after the latest amendments, if you sell these investments on or after July 23, 2024, the gains will be taxed at a new tax rate of 12.5% without any indexation benefit.

What is the new LTCG tax rate for debt mutual funds after July 23, 2024?

From July 23, 2024, the new long-term capital gains (LTCG) tax rate for both listed and unlisted securities is 12.5%, without any indexation benefits. However, this change does not apply to debt mutual funds. Gains from these funds will continue to be taxed according to your income tax slab rate and not the 12.5% LTCG rate.

Will the removal of indexation benefits impact my tax liability on debt mutual funds?

With the removal of indexation benefits, you can no longer adjust the purchase price of your debt mutual funds for inflation. This increases your tax liability, especially if your returns are close to the Cost Inflation Index (CII).

Before the amendment, the LTCG tax rate was 20% with indexation benefits. This allowed for lower taxable gains. But now, without this benefit, your capital gains will be taxed at your regular income tax rate, and you cannot adjust your purchase price for inflation.

Are there any changes to the carry-forward and set-off rules for losses on debt mutual funds?

There are no changes to the rules for carrying forward and setting off losses on debt mutual funds. If you have losses from debt mutual funds purchased before April 1, 2023, you can still offset them against capital gains from other assets.

Be aware that as per the Income Tax Act, short-term losses can offset both short- and long-term gains, while long-term losses can only offset long-term gains. Moreover, these losses can be carried forward for up to 8 financial years.

How does the LTCG tax change affect different types of debt mutual funds?

It must be noted that the new long-term capital gains (LTCG) tax rules apply to all debt mutual funds. However, the way these rules affect your returns will depend on the specific type of debt fund. That’s because different funds, such as overnight, medium, and long-duration funds, have varying risk levels and investment periods.

For example, overnight funds are short-term and have lower risk, while long-duration funds have a longer investment horizon and may involve more risk. These differences will influence how much the tax changes will impact your overall returns.

What should investors consider before redeeming debt mutual funds purchased before April 1, 2023?

If you bought debt mutual fund units before April 1, 2023, and decide to redeem them after July 23, 2024, the long-term capital gains (LTCG) from these units will be taxed at a flat rate of 12.5%, but without the benefit of indexation. Previously, these gains were taxed at 20% with the indexation benefit.

Moreover, after the latest changes proposed in the new budget released on July 23, 2024, the LTCG will be taxed at the investor’s applicable income tax slab rate. Additionally, the holding period required to qualify for LTCG treatment has been reduced from 36 months to 24 months.

How are equity mutual funds taxed after Budget 2024?

Short-term capital gains from equity mutual funds (held for up to 12 months) are now subject to a 20% tax rate. Long-term capital gains (held for more than 12 months) are taxed at a uniform rate of 12.5%.

How has the holding period for debt mutual funds changed?

Debt mutual funds purchased before April 1, 2023 can be considered long-term if held for over 24 months. However, those purchased after April 1, 2023 will always be taxed as short-term gains.

What is the impact of the removal of the indexation benefit on long-term capital gains?

The indexation benefit has been eliminated. As a result, all asset classes are now subject to a uniform 12.5% long-term capital gains tax. Previously, some assets enjoyed a 20% tax rate with indexation.

How are foreign equity ETFs and gold ETFs taxed under the new rules?

Foreign equity ETFs listed in India are now taxed as short-term capital gains if held for up to 12 months. Gold ETFs purchased after April 1, 2023 are also taxed as short-term gains if held for up to 12 months.

Are there any changes in the taxation of conservative hybrid funds?

Conservative hybrid funds purchased before April 1, 2023 can be considered long-term if held for more than 24 months. However, those purchased after April 1, 2023 will always be taxed as short-term gains.

How will debt mutual funds be taxed under the new rules?

The tax rate for debt mutual funds remains unchanged. They will continue to be taxed according to the investor's income slab rate

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