# Capital Gains Tax on Debt Mutual Funds after Budget 2014

Budget 2014: Capital Gains Tax on Debt Mutual Funds

We had always recommended keeping some part of your investment in Fixed Income instruments in Debt Mutual Funds like FMPs, Liquid Funds, etc. especially if the investment is for more than a year and you are in higher tax brackets of 20% or more.

Budget 2014 has come as shock to investors following this strategy. There are two major changes in which the returns on these funds would be taxed:

1. To qualify for long term capital gains, the investment period has been increased from 1 year to 3 years.
2. The long term capital gains would now be taxed at the rate of 20% after taking indexation benefit on account. Earlier this tax was minimum of (flat 10% on gains or 20% after taking indexation benefit).

So the investment period between 1 to 3 years are majorly impacted.

## The Tax Calculation:

We understand the above change through an example:

You invested Rs 1 Lakh in debt fund in April 2012 and redeemed it in April 2014 for Rs 1.2 Lakhs. For simplicity we assume the inflation was 8% for both the financial years.

#### Earlier Taxation:

• Gross Gains = 1,20,00 – 1,00,000 = Rs 20,000
• Investment Tenure = 2 Years [so qualifies for Long Term Capital Gains]
• Initial Capital Adjusted for Inflation = 1.08 * 1.08 * 1,00,000 = 1,16,640
• Tax = minimum (10%*20,000 or 20% *(1,20,000 – 1,16,640)) = minimum of (2,000 or 672)

So you paid tax of Rs 672 on gross gains of Rs 20,000 i.e. 3.4% tax!

#### New Taxation:

In the new taxation regime the above gain would be treated as short term capital gains and taxed according to marginal tax rate.

So the tax outgo would be Rs 2,060 (at 10% tax), Rs 4,120 (at 20% tax) and Rs 6,180 (at 30% tax bracket). So you can see how bad this change is investors in terms of tax outgo!

## Which Funds are Impacted?

This change is not limited to Debt Mutual funds but it applies to following:

1. Debt funds
2. Gold funds
3. Infrastructure non-equity funds
4. Monthly Income plans where equity is < 65%
5. Fund of Funds
6. Any Mutual Fund where the equity part of portfolio is less than 65%
7. Unlisted Shares

## What Happens to Redemption after April 1, 2014?

Update July 25, 2014The Finance minister has clarified that the new tax would be effective only for Redemption after July 10, 2014.

The worst part is the above tax change is effective from April 1, 2014. So if you had invested in FMPs or Liquid Funds in last 2 years and redeemed it after April 1, 2014 – your return calculation would go haywire as in the example above.

I personally take this move for government as very negative as this is retrospective taxation, which the government is opposing in the first place. Also such sudden taxation changes make personal financial planning go haywire. This change should ideally been done for new investments only! You can never trust that the PPF or EPF which is tax free till date even on withdrawal might remain so 10 years from now.

## The Dividend Option?

The Dividend Distribution Tax (DDT) on Debt Funds is 25% + 10% Surcharge + 3% education cess, effectively making DDT as 28.33%. This tax rate has not changed but there has been a change in the way DDT is levied. With Budget 2014, DDT would be levied on Gross Dividends rather than Net Dividends.
So the effective DDT rate was 22.1% but now it would be 28.33%.

So, dividend option in debt mutual fund might still be slightly better option for people in 30% tax bracket.

## The New Strategy?

So with the new changes what should be your strategy for fixed income investments?

Fixed Deposits (FD) offers guaranteed returns while in case of debt funds the return is not know in advance. Also with the new regulation the taxation on both would be same for 3 years. So in case you are in 30% tax bracket you might choose dividend option of debt fund (tax of 28.33%) for investments up to 3 years. For all others FDs would be good option. For more than 3 years, debt mutual funds with Growth option would still be preferred.

However there are two things you might note:

1. In case of FD, banks deduct 10% TDS while there is no TDS in case of Debt Mutual Funds.
2. For FDs you need to pay taxes annually, even though the interest has not been actually paid to you. In case of mutual funds, the tax needs to be paid only at the time of redemption.

Did you invest in Debt Mutual Funds and what would be your new strategy?

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