Contradiction between taxation of bonds and bond mutual funds

In debt mutual funds, the required holding period for eligibility for LTCG taxation is three years. If the holding period in debt mutual funds is less than three years, it is Short Term Capital Gains (STCG), which is taxable at your marginal slab rate. LTCG in debt funds is taxable at a defined rate of 20% plus surcharge and cess, but after the benefit of indexation, which significantly reduces taxation.

In other words, for tax efficiency, you need to hold your debt funds for more than three years.

For the sake of clarity, the benefit of indexation is not available in the bond. There is a misconception in certain sections that indexation is available in bonds. This could possibly arise from the fact that it is available in debt funds and there is a similarity between the two. Under section 48 of the Income Tax Act, the second proviso provides for the benefit of indexation and the third proviso excludes bonds/debentures from this benefit. Sovereign gold bonds are an exception where indexation is available.

There is widespread talk that in the upcoming Union Budget to be presented on February 1, the Finance Ministry is looking to bring uniformity in taxation of capital gains. Currently, the required holding period for LTCG is one year for equity stocks and equity funds, two years for real estate and three years for debt funds. In a way, there is an unbalanced message from the authorities that the holding period should ideally be one year for equity funds and three years for debt funds. Given the volatility of equity and debt as asset classes, it should be the other way around.

The contradiction between the taxation of bonds and bond funds is that the holding period required to qualify for LTCG is one year for bonds and three years for bond funds. Bond funds being the preferred vehicle for fixed income investments for most people, there is a strong case to be made for bringing the two on a single platform. This can be done either by reducing the required holding period for mutual funds, or by increasing or halving the period for bonds. If the holding period of LTCG for debt funds is reduced to two years, it will encourage people to come into debt funds and incentivize the vehicle.

Another aspect that the finance ministry may consider is the benefit of indexation for bonds. If so, then the holding period requirement for LTCG may be extended from the existing one year. The tax revenue impact for the government would not be much, since most of the return from bond investment comes from coupons (interest) and only a small portion from capital gains, if it is sold at a profit before maturity. Being an important source of resource raising for corporate India after equity, it needs to be encouraged at least to some extent.

For investors, there is no action point ahead of the Union Budget. If there is a change in the taxation rules for bonds or bond funds announced on February 1, 2023, the other variable is the applicable date. If there is a grandfathering clause i.e. it is made applicable only to new investments after the cut-off date, then your existing investments will be taxed as is done at present. If the status quo is maintained in the Union Budget, tax efficiency can be availed by investors through the MF route, provided the investment horizon is at least three years.

The beauty of debt mutual funds from a tax perspective is that all inflows, including coupon inflows, are taxed at an effective rate.

Joydeep Sen is a Corporate Trainer and Author