Taxation of Debt Mutual Funds

Debt Mutual Funds invest in bonds and fixed-income securities and offer returns with lower volatility compared to Equity Mutual Funds. For the purpose of taxation, any fund in which equity or equity-related securities don't exceed 65% is considered a Debt Mutual Fund.

One of the advantages of Debt Mutual Funds is that Long-Term Capital Gains offer the benefit of indexation. Let us take a closer look.

Taxation of all Debt Funds depend on two factors: 

1) Is it a Growth or Dividend Plan?

2) How long is the Mutual Fund held?

As for the first one, Budget 2020 abolished the Dividend Distribution Tax and made dividends earned out of Mutual Funds taxable at the tax slab of the investor. To illustrate, your income from a Dividend Plan of a Mutual Fund will be added to your income and taxed according to whichever slab you come under. In this article, we will focus on taxation of Debt Funds under the Growth Plan.

As for the second, gains from Debt Mutual Funds held for less than 3 years are considered as Short-Term Capital Gain (STCG) and taxed at slab rate. If the fund is held for longer than 3 years, the gains fall under LTCG and provide the benefit of indexation for tax treatment.

LTCG tax for Debt Funds = 20.8%* ✕ LTCG**

Note: 

*LTCG on Debt Funds are taxed at a base rate of 20%. However, for Assessment Year 2020-21, a health and education cess at 4% the base tax. Hence, in this case, it would be 20% (base rate) + 4% (cess) ✕ 20% (base rate) = 20.8%

**The LTCG is calculated after indexation

What is Indexation?

As you would be aware, inflation reduces the purchasing power of money with each year. Indexation is a simple calculation that provides an inflation-adjusted cost of acquisition, i.e. Indexed Cost of Acquisition (ICOA). Let us illustrate the tax benefit of indexation with an example.

Let us suppose that you bought Debt Funds in October 2013 (FY 2013-14) for Rs. 10 lakhs at an NAV of Rs. 20. In November 2018 (FY 2018-19), you redeemed it at an NAV of Rs. 30, a gain of 50% over the price you bought. Since the period is more than three years, it will be treated as LTCG and indexation will be used to calculate the ICOA.

Indexation is calculated using the Cost Inflation Index (CII), an index maintained by the Department of Income Tax. The CII for FY 2013-14 is 220 while it is 280 for FY 2018-19. The formula for calculating the ICOA is given below.

The formula for ICOA = Cost of Acquisition ✕ {CII for the year of redemption/sale ÷ CII for the year of purchase}

Step 1

Thus, ICOA = Cost of Acquisition in FY 2013-14 ✕ {CII for FY 2018-19 ÷ CII for FY 2013-14}

Step 2 

ICOA  = Rs. 10 lakhs ✕ {280 ÷ 220} = Rs. 12.73 lakhs

Step 3

LTCG for taxation is: 

Price of redemption - Indexed Cost of Acquisition (ICOA)

Rs 15 lakhs - Rs. 12.73 lakhs = Rs. 2.27 lakhs. 

Step 4

LTCG tax for Debt Funds: 

20.8% ✕ Rs. 2.27 lakhs = Rs. 47,216 

Thus, you will pay 9.44% (Rs. 47,216 ÷ Rs. 5 lakhs)  of your gains as tax. 

Comparison with FD

Although the ROI of 8.5% per annum of this debt fund is slightly more than a typical FD, we can still compare the post-tax returns of the two products. In case of an FD, any interest amount over Rs. 40,000 per annum will be deducted at source as TDS (Tax Deducted at Source).

Since the gain is 50% over 5 years, the IRR is 8.5%. Therefore, the total tax liability over the period could be anywhere from 10% (Rs. 50,000) to 30% (Rs. 1.5 lakhs), depending on the tax slab.

In other words, for interest greater than Rs. 40,000 per annum, the pre-tax and post-tax returns of debt funds is better than FDs.