Till 31 March of last year, debt funds were eligible for indexation benefit for the purpose of long-term capital gains (LTCG) tax. This is a benefit that reduces the impact of inflation on LTCG, given that part of the gains in investment accrues from inflation. Since 1 April 2023, capital gains from debt funds are taxable as short-term capital gains (STCG), irrespective of the holding period. In other words, LTCG and indexation benefits are no longer available. However, the Finance Act of 2023 opened up another category in mutual funds (MFs) for taxation purposes. Funds with more than 65% exposure to equity remain taxable as equity. Funds with less than 35% exposure to domestic equity are taxable as STCG, irrespective of holding period. Funds with 35-65% exposure to equity are still eligible for indexation, which is the new category for taxation purposes.
How does this work? You require a holding period of three years to be eligible for indexation. Your purchase cost is ‘indexed up’, as per cost inflation index (CII) published by the Central Board of Direct Tax. The differential between your indexed purchase price, and sale or redemption price is taxable at a flat rate of 20%, besides the applicable surcharge and cess. As an illustration, let us say you had purchased MF units in March 2020 at a cost of ₹10 per unit. You redeemed the units in July 2023 at a price of ₹13. Apparently, your capital gain is ₹3 per unit. Now, the purchase price of ₹10 will be ‘indexed up’. The CII for financial year 2019-20 was 289 and that for 2023-24 was 348. Hence your purchase price, for the purposes of long-term capital gains, becomes ₹ 12 (348/289 x ₹10 [ignoring paisa for simplicity]). ₹1 is taxable at 20%, ignoring surcharge and cess. Hence you pay a tax of 20 paisa on capital gain of ₹3, which implies an effective tax rate of 6.67% on the gains.
There is a ‘March effect’ in this. The starting point of your “meter” so to say, for computation of indexation, is the financial year in which you make the investment. Either you make the investment in April of that financial year or March, does not matter. Hence, if you invest in March, even without remaining invested since previous April or some other month of the year, you get the same benefit. If you invest in March this year, your starting point will be the CII of 2023-24. If you redeem in say April 2027, you are remaining invested for little more than three calendar years. For computation of indexation, your starting year is 2023-24 and terminal year is 2027-28. That is, you get the benefit of four CII numbers for indexation purposes.
Now the question is, which are the funds that are eligible, in the bracket of 35 -65% exposure to domestic equity. There are certain multi asset funds (MAFs) positioned in this bracket. To be noted, not all MAFs are eligible for indexation—it depends on the positioning by the AMC: MAFs with more than 65% domestic equity are taxable as equity funds. A few are positioned for taxation with indexation benefit. There is one MAF where the equity component is hedged, like in arbitrage funds. That makes it a quasi-fixed-income fund with indexation benefit. Recently, one balanced advantage fund (BAF) has been positioned in this category. In this fund, domestic equity will be little less than 65% and obviously much more than 35%. BAF funds would gain less than equity funds in a market rally but will lose relatively less in correction phase.
For fresh investments in debt funds, investors should open fresh folios. This is to avoid confusion in taxation. For taxation purposes, redemptions are tracked on first-in-first-out (FIFO) basis. Your investment till 31 March 2023 may not have completed 3 years from the date of investment till today/date of redemption, which is required for indexation benefit. You may want to continue with the taxation advantage; three years is the minimum eligibility for indexation. New folios will keep the demarcation clear, for deployments after 1 April 2023.
Joydeep Sen is a corporate trainer (financial markets) and author.