The mutual fund (MF) industry is hopeful that the government may restore the indexation benefit for computing capital gains on the sale of debt-oriented funds. This crucial tax adjustment, which was removed in the Finance Bill 2023, is expected to be revisited in the upcoming Budget FY26, according to sources.
Why the Demand for Indexation Restoration Has Strengthened
The withdrawal of indexation has significantly impacted post-tax real returns for investors in debt MF schemes. Persistent high inflation has eroded returns, making debt mutual funds less competitive compared to bank fixed deposits. The indexation benefit, which adjusts the cost of capital assets for inflation over the holding period, previously helped debt MF investors mitigate tax liabilities.
The mutual fund industry has also urged the Finance Ministry to align the capital gains tax on debt MFs with the tax rate on listed bonds, proposing a 12.5% tax rate for long-term capital gains (LTCG) on debt MFs held for over a year.
Changes in Taxation of Debt MFs
Since April 1, 2023, capital gains on debt mutual funds are taxed at the investor's income tax slab rate, irrespective of the holding period. Previously:
- LTCG was taxed at 20% with indexation or 10% without indexation.
- Short-term capital gains (STCG) were taxed as per income tax slab rates for holdings up to three years.
This tax change has increased liabilities for investors, discouraging participation in debt funds. The Association of Mutual Funds in India (Amfi) has repeatedly called for the restoration of the indexation benefit for investments made before March 31, 2023, to preserve investor confidence.
Real Returns and Investor Sentiment
Debt funds have delivered average returns of 7% over the past 3-5 years, while inflation has hovered around 5.5%, resulting in a real income of only 1.5%. According to Amfi, the withdrawal of indexation is not just a financial setback but also undermines investor trust, potentially deterring retail investors from choosing mutual funds for long-term investments.
Industry's Proposal for Tax Parity
The MF industry is advocating for debt MFs to be classified as "securities" instead of "special mutual funds" under the tax laws. This classification would ensure that long-term investments in debt MFs are taxed at 12.5%, similar to listed bonds.
Broader Reforms for Financial Instruments
The MF industry has also sought a uniform LTCG holding period for gold-related investments like gold ETFs, gold mutual funds, sovereign gold bonds, and physical gold. Currently, gold MFs and physical gold qualify as LTCG after 24 months, while the rest qualify after 12 months.
Recent Developments
In the July 2024 Budget, indexation benefits were removed for LTCG across all asset classes, including bonds. However, after facing backlash from the real estate sector, the government restored indexation benefits for real estate properties purchased before July 23, 2024. This development has rekindled hopes for the mutual fund industry to regain indexation benefits for debt MFs.
Growing Debt Fund Market
Despite these challenges, the debt fund market has grown substantially. As per the latest Amfi data:
- Debt funds' AUM stood at ₹16.86 lakh crore as of November 30, 2024, up from ₹12.57 lakh crore a year ago.
- Gold ETFs grew to ₹44,244.82 crore, doubling from ₹20,832.77 crore a year earlier.
Conclusion
Restoring the indexation benefit for debt mutual funds in the Budget FY26 could provide much-needed relief to investors, bolster confidence in the fixed-income market, and align taxation across financial instruments. As the government deliberates these proposals, the decision will significantly impact retail investors and the broader mutual fund industry.
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