Central Idea

The Finance Bill 2023, passed by the Lok Sabha with 64 amendments, includes the controversial decision to remove the tax benefit for debt mutual funds. While the aim is to remove the advantage of debt funds over bank deposits, this decision will have far-reaching consequences that need to be examined.

Mutual Funds

Investment decisions on behalf of the investors: Mutual funds are investment vehicles that pool money from multiple investors to purchase a diversified portfolio of stocks, bonds, or other securities. Mutual funds are managed by professional fund managers who make investment decisions on behalf of the investors in the fund.
Diversified portfolio of securities: Investors in a mutual fund own a proportional share of the fund’s underlying assets, and the value of their investment rises or falls in response to changes in the value of the securities held by the fund. Mutual funds can provide investors with access to a diversified portfolio of securities, which can help to mitigate the risk of investing in individual securities.

Mutual funds and debt mutual funds are both types of investment funds, but there are some key differences between them

Comparison	Mutual Funds	Debt Mutual Funds
Types of Investments	Stocks, bonds, commodities, and other asset classes	Fixed-income securities such as bonds, debentures, treasury bills, and commercial papers
Risk	Generally higher risk due to the inclusion of stocks and other volatile assets	Generally lower risk due to the focus on fixed-income securities
Returns	Potentially higher returns over the long term, but subject to more volatility	Lower returns compared to equity mutual funds, but also come with lower risk
Investment Objective	Can vary widely depending on the type of fund	Provide regular income to investors while preserving capital
Liquidity	Can be less liquid than debt mutual funds due to volatility in underlying securities	Generally considered more liquid due to less volatility in underlying securities

Removal of the tax benefit for debt mutual funds: The Finance Bill 2023 passed by voice vote in the Lok Sabha last week with 64 amendments, including the removal of the tax benefit for debt mutual funds.
What it means: This change means that investors in debt mutual funds cannot avail the benefit of indexation for the calculation of long-term capital gains. From April 1, such investments will now be taxed at income tax rates applicable to an individual’s tax slab.
Motive: This move aims to remove the advantage that such debt funds have over bank deposits. However, the consequences of this decision need to be carefully examined.

Impact on flow of funds: The removal of the tax benefit will lead to investors reassessing their allocations to debt mutual funds, which may impact flows into these funds.
Impact on bond market: This, in turn, may impact the growth and development of the bond market in India since debt mutual funds channel funds into the bond market.
For instance: According to a report by Crisil, 70% of the investment in debt funds flows from institutional investors, while individual investors, including high net worth individuals, accounted for 27% as of December 2022.
Impact on corporate debt: This change in rule may trigger a shift in investments away from debt mutual funds to other instruments, which will possibly affect flows to the corporate bond market, and demand for corporate debt is likely to be impacted.

There is a need to acknowledge the finer points of differentiation between bank deposits and debt funds since bank deposits are insured up to Rs 5 lakh while debt mutual funds carry risk depending on the risk profile of the bonds they hold.
It has been argued that the capital gains architecture in India needs to be reexamined and reconfigured.
Not only are there different rates of taxation for different asset classes, but even the holding period for differentiating between short- and long-term capital gains varies across assets. Thus, rationalisation with regard to the tax rate and/or the holding period is desirable.

While the removal of the tax benefit for debt mutual funds may remove the advantage of such funds over bank deposits, its far-reaching consequences need to be carefully examined. There is a need to acknowledge the finer points of differentiation between bank deposits and debt funds, as well as rationalisation of the tax architecture in India. Therefore, there is a need for broader discussions and debates on these issues.

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