Debt funds are taxed differently after changes to the Finance Bill 2023. This is old news I know, but I did not plan on writing anything about it because it does not change anything in my financial plan. But a reader asked my opinion and I thought I will do a quick post. Remember that anything that I write in my blog is not financial advice for people at large. It is just a recount of my experience and how various investment opportunities or taxes are applicable to my specific situation. Even if some one is exactly in my situation, my advice or experience may not apply to them because it also has to do with the mindset. So unless you are in my exact situation both financially and mentally, most of what I write may not even be relevant to you.
You might already know this but I will give a quick update on what has changed with debt funds taxation. Before April 1, 2023, any short term capital gains were taxed at applicable rate and long term gains were taxed at 20% after indexation. Short term means if you sold your investments before 3 years from the date of investment. Long term means you held your investments for 3 years or more before selling them. Capital gains is the profit you make when you sell your investment at a price higher than your purchase price. For example say you bought a debt mutual fund for Rs. 50K and sold it at Rs. 70K, then the Rs. 20K profit you made is the capital gains.
Now, depending on whether you sold your investments before 3 years or after, that Rs. 20K capital gain could be a short term capital gain or long term capital gain. Short term capital gains were taxed at applicable rate. Tax at applicable rate means that the capital gains will be added to your income for the financial year and depending on which tax slab your income falls under, you will taxed at that rate. This taxation on short term capital gains has not changed.
The tax on long term capital gains is interesting. Before April 1, 2023 long term capital gain is calculated after indexation. What is indexation then? Suppose you purchased a debt mutual fund in 2015, and sold in 2020, you can use the cost inflation index (CII) to find the CII for 2015 and 2020. Then multiply the purchase price by CII of 2020 and divide it by CII of 2015. In the current example, the indexed purchase price is Rs. 50K x 301 / 254 = Rs. 60K. Now your capital gain is Rs. 70K - Rs. 60K = Rs. 10K instead of Rs. 20K. So you reduced your gains. Then, the tax on the capital gains is 20%, so you pay 20% of Rs. 10K = Rs. 2K as tax. That indexation reduced your tax from Rs. 4K to Rs. 2K.
What has changed after April 1, 2023 is that both short term capital gains and long term capital gains will be taxed at applicable rate. The benefit provided by long term capital gains is gone now. So whether you sell after 3 years or not you will have to add the gains to your income for the financial year and pay tax on it.
If you are with me so far, then good for you, because things will start to become more complicated. Since I am retired, I prefer to have short term capital gains rather can long term capital gains even before this amendment came into effect. Let me explain that a bit. Suppose, I have a capital gain of Rs. 7 lakhs, lets see how much tax I will have to pay if that capital gain is short term and long term. First the short term capital gains tax. From FY 2023-24, the first Rs. 3 lakhs of income is not taxable. For the rest of Rs. 4 lakhs the tax is Rs. 25K. Thankfully there is tax relief u/s 87A of Rs. 25K which cancels out the tax and you pay nil. So all your capital gains are tax free.
Now lets take the other case. What if the Rs. 7 lakhs is your long term capital gain after indexation. Like before, the first Rs. 3 lakhs is tax free. Then you have to pay a tax of 20% on Rs. 4 lakhs which is Rs. 80K. After tax relief u/s 87A, I have to pay a tax of Rs. 55K + cess. As you can see, for a low income person like me, the short term capital gains tax is actually beneficial. I am one of those people with low income. Why do I have such low income? Because I have no salary, or rent or FD interest or any other income sources except for the mutual funds that I sell at my own discretion when I want to sell them. I intentionally sell in such a way that my total short term capital gains are less than Rs. 7 lakhs for the financial year. But there is more, depending on when you buy and sell, the gains can change.
Suppose you invested Rs. 100 lakhs one year ago and sold it this year. Assuming a 7% return on investment, your investment should have grown to Rs. 107 lakhs. Assuming for some reason you needed Rs. 107 lakhs, you sold all your investments and thus you have a Rs. 7 lakhs short term capital gain. Now take the long term capital gains case. Suppose you invested some amount of money 3 years ago and now the value is Rs. 107 lakhs. You need all of that money so you sold it all. Now, what was the amount that was invested 3 years ago? It is Rs. 107 lakhs / (1 + 7%)3 = Rs. 87 lakhs. Then indexed price (using CII for 2023 and 2020) is Rs. 87 lakhs x 331 / 289 = Rs. 100 lakhs. Hence the capital gains is Rs. 7 lakhs. In this particular example, both the short and long term capital gains are the same, but you pay zero tax for short term gains and more than Rs. 55K for long term gains.
Take another example. Assume the same investment period for short term capital gains. So you invested Rs. 100 lakhs in 2022 and sold it for Rs. 107 lakhs in 2023. However for long term, lets assume you invested in 2018 and sold Rs. 107 lakhs in 2023. Then your investment in 2018 is Rs. 107 / (1 + 7%)5 = Rs. 76 lakhs. After indexation it is Rs. 76 x 331 / 272 = Rs. 93 lakhs. In this case the long term capital gains are Rs. 107 lakhs - Rs. 93 lakhs = Rs. 14 lakhs, which is twice that of the short term gains! The tax to be paid will be almost Rs. 2 lakhs. So if you need Rs. 107 lakhs for some purpose, you have to pay a lot more taxes if you have long term investments, while you pay no tax if it was all short term gains.
Of course if you used a different rate of return instead of 7% then the calculations will be different. If you choose different years, then the CIIs will be different and the gains will be different yet again. As you can imagine, there will be a lot of permutations and combinations that makes these calculations quite complex. And you know me, I always prefer simple over complex. As such I always prefer the simple short term capital gains.
So the changes to the debt funds taxation do not affect me. In fact I prefer the short term capital gains. For investors in higher tax slabs it may be a disadvantage. You may want to invest in arbitrage funds but I am not sure if the returns will be as good going forward given that everyone might join the arbitrage band wagon. Anyway, like I mentioned before, I talk about specifically my situation and these new tax rules have not changed anything in my financial planning. I like to keep things really simple, so I am not planning on arbitrage funds or anything like that.
Remember that tax rules keep changing all the time. What you plan today may not work tomorrow. So try to be flexible and invest according to your goals and not according to taxes. Yes, you can save a few bucks if you play the tax game well, but you cannot be the winner for ever. Rather than focussing too much on the taxes which have a smaller impact on your over all financial goals, work on the things that give the best bang for buck like asset allocation, increasing income, reducing expenses. Once you have done all that, you can work on optimizing taxes.
Also, think in long term. Today you may think that that the change in taxes is a cause for concern. But perhaps you never need to sell your debt mutual funds at all until you retire. At that point the taxes might have changed considerably and nothing you had planned some 10 years ago makes any more sense. Moreover, you may be selling so little of your investment to match your expenses that you are always below the lowest tax bracket like me. Then it does not even matter what the tax on it is. Just in the last 10 years of my investment, taxes have changed so many times. The long term capital gains on equity mutual funds used to be zero and now it is 10%. No long term capital gains in debt MFs. Tax slabs have changed twice. Tax relief u/s 87A was changed twice etc.
Just go with the flow. You cannot change the investments that you already made. For future investments you can plan something based on current tax laws, but remember that they are bound to change sooner or later and may not apply in the future. Make investment decisions based on financial goals.