LTCG

Description

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Context

The government has proposed changes in the taxation of debt mutual funds.

ALL ABOUT MUTUAL FUNDS: https://www.iasgyan.in/daily-current-affairs/mutual-fund

ALL ABOUT INFLATION: https://www.iasgyan.in/daily-current-affairs/inflation-29

BACKGROUND

Capital Gains

Capital Gains are the gains earned from the sale or transfer of assets that include shares, bonds, real estate, gold, debentures and related instruments.
Simply put, Long Term Capital Gains (LTCG) are the capital profits from the long-term investment of the assets while Short Term Capital Gains (STCG) are gains earned from the sale of short-duration assets.

How have debt mutual funds been taxed until FY2022-23?

Until March 31, 2023, income tax laws allow taxation of these debt mutual fund schemes on the basis of a holding period.
If the debt mutual fund scheme unit is redeemed on or before the completion of 36 months (3 years), then the gains on the units are called short-term capital gains. Short-term capital gains are taxed at tax rates applicable to the individual’s income.
However, if the holding period exceeds 36 months, the gains are called long-term capital gains (LTCG). Long-term capital gains are taxed at 20% with an indexation benefit.

Note: Indexation means adjusting the cost of funds after taking into account inflation in the redemption cost. It helps to calculate the new value of the investment after considering inflation over the same period.

CALCULATION OF INDEXATION

Since indexation is used for arriving at an adjusted price of purchase after considering inflation, a Cost of Inflation Index (CII) is used for indexing (adjusting) the purchase price.

This Cost of Inflation Index number is notified by the Finance Ministry for every Financial Year and is available on the Income Tax Website

For arriving at the adjusted cost of acquisition of the Debt Fund units, we divide the Cost Inflation Index of the year in which the units are sold by the Cost Inflation Index of the Year in which these units were acquired and then multiply the figure by the actual cost at which the units were purchased.

This will give the adjusted price which can be used for calculating the Long Term Capital Gains.

For Example – Mr. A purchased 5000 units of Debt mutual fund XYZ at Rs18 in the Financial Year 2012-13 and then sold these at Rs 27 in the Financial Year 2018-19. (As the units were held for more than 36 months, this transaction qualifies for indexation benefit)

The profit realized in the transaction is: 5000 (27-18) = Rs 45000

First, we arrive at the Inflation adjusted purchase price:

Inflation-adjusted Purchase price: ( 280 /200)*18 =25.2

Then we calculate the LTCG for the transaction:

5000 x (INR 27- INR 25.2) = INR 9000

(Here Cost Inflation Index number for 2018-19 is 280 and that for 2012-13 is 200. The numbers have been taken from the Income Tax Site).

COST INFLATION INDEX VALUE (CII)

The cost of inflation index is a method through which we can calculate long-term capital gains from the sale of the assets. The inflation rate that is used in indexation is taken from the cost inflation index (CII) of the government. The value in the index is identified by the Central Government every year and is updated on the website of the Income Tax Department.

Tax Rate On Long Term Capital Gains For Debt Funds

The tax rate for LTCG on Debt Funds is 20%. (Overall it will be 22.88% after including a surcharge of 10% and education cess of 4%)

This is much better than the tax levied for other Fixed Income instruments like bank Fixed Deposits.

Tax Calculation for our example

Applicable Tax: 22.88% of INR 9000= INR 2059 as against INR 10296 (22.88% of INR 45000)

(Thus a substantial saving of INR 8237 {INR 10296- INR 2059})

INDEXATION BENEFIT IN MUTUAL FUNDS

The concept of Indexation makes investment in Debt mutual funds a lucrative proposition as it provides investors with an opportunity to earn reasonably better post-tax returns.

This is because indexation helps in significantly reducing the capital gains by way of using the Cost of Inflation Index.

Higher inflation rate increases the cost of acquisition (purchase price) of units which results in a decrease in profit and hence lesser capital gains. This in turn lowers the tax burden.

What does the amendment propose?

It is proposed to tax the income from debt mutual funds at an applicable rate since it is of the nature of interest income.
Accordingly, the benefit of indexation for calculation of LTCG on debt mutual funds will not be available for investments made on or after April 1, 2023 — in those debt mutual fund schemes where less than 35% of the total proceeds is invested in equity shares of domestic companies.
These investments will now be taxed at income tax rates applicable to an individual’s income slab. This will bring investments in debt mutual funds at par with investments in bank fixed deposits.

In a nutshell,

Changes made

According to the new changes the benefits of indexation for the calculation of long-term capital gains (LTCG) on these funds will stand withdrawn for investments made on or after April 1, 2023.
The changes will be applicable to debt-oriented mutual fund schemes that invest a minimum of 65% of their corpus in debt securities, and only up to 35% in equities.
These funds will no longer have a tax arbitrage over bank fixed deposits, where the interest income is taxed at the marginal tax rate of the individual.

Many feel that the removal of tax arbitrage and the creation of a consistent tax policy across all debt instruments is good news for banks looking to attract customers with higher interest rates and to increase their borrowing and savings book sizes.

Impact on investors: Understanding through an example

Suppose you had invested Rs 2 lakh in a debt mutual fund (investing less than 35% in equities) in March 2018 and, after five years in March 2023, the value of the investment has grown to Rs 3 lakh. As per the current regime, the benefit of indexation will be applied — and your capital gains will not be Rs 1 lakh, but will be adjusted for inflation over five years.
So, if the cost of index inflation rises from 100 to 125 in this period, the cost of acquisition will be treated as Rs 2.5 lakh instead of Rs 2 lakh (Rs 2 lakh x 125/100) — and your capital gains would amount to only Rs 50,000 (Rs 3 lakh minus Rs 2.5 lakh). And you will be required to pay 20% tax on Rs 50,000, which is Rs 10,000.
Now, after the indexation benefit is withdrawn from April 1, 2023, if you make a similar gain over the next five years, you will have to pay tax at the marginal tax rate. The tax will be calculated on gains of Rs 1 lakh (Rs 3 lakh minus Rs 2 lakh). And if you are in the 30% tax bracket (31.2% including cess), you will be required to pay a tax of 31,200.

How will debt mutual funds be impacted?

According to Industry experts, the removal of the indexation benefit from debt mutual funds is a major loss for bond markets that are still struggling with liquidity. Mutual funds are the only large active institutional investors that bring liquidity in the bond market.
This could result in investors seeking out other options. It may have a negative impact on all debt funds, particularly in the retail category, as ultra-high net worth and high net worth individuals may choose to invest in safe havens like bank fixed deposits.

MAINS PRACTICE QUESTION

Q. The growth of the Mutual Fund Industry in India has created its edge in the personal finance industry in India and has opened up opportunities to investors in order to diversify their investments across assets. Discuss.

https://indianexpress.com/article/explained/explained-economics/indexation-benefit-on-ltcg-gone-debt-mfs-8517412/