How are Debt Mutual Funds Taxed in India?

Today, we will talk about how Debt mutual funds are taxed. Debt mutual funds are quite popular among risk-averse investors who want to keep their money safe.

A Debt mutual fund invests in Government Securities, Corporate Bonds, Treasury Bills, Certificate of Deposits, etc. Thus, people who do not want to invest in Equity mutual funds but want to earn a little bit more return than bank fixed deposits or other Debt options take the route of Debt mutual funds.

It is also popular among aggressive investors (investors who prefer risky investments) and institutional investors (banks, pension funds, insurance companies, etc.). They like to park their money for the short term in Debt mutual funds.

The mutual fund industry is growing very fast. For example, by the end of July 2020, the industry manages 27.28 trillion rupees. In numbers, it will look like this 27,280,000,000,000. Further, it is quite surprising that more than 50% of this amount has come via Debt mutual funds. It includes Debt Funds (30.1%) plus Liquid or Money Market Funds (23.1%) – Date source: Association of Mutual Funds in India (updated up to July 2020).

We will dedicate a complete series of mutual funds in our subsequent session. Therefore, if you plan to invest in Debt mutual funds or already an investor and want to know how the profits are taxed, this post is for you.

How are Debt Mutual Funds Taxed?

When you sell a Debt mutual fund and make a profit, we call it capital gain. For example, suppose you invested Rs 10,000 in a Debt mutual fund, and it became Rs 15,000 at the time of redemption. Then, your capital gain is Rs 5,000.

Rs 15,000 (Redemption amount) – Rs 10,000 (Invested amount) = Rs 5,000 (Capital gain)

However, capital gains can be SHORT TERM or LONG TERM. And, the tax treatment for both of the capital gains is different. Let’s see how both short term capital gain and long term capital gain in Debt mutual funds are taxed.

Short term capital gain Tax

If you hold Debt mutual funds units for less than 36 months, then the profit you make on such investments will attract short term capital gain tax. Next, the profits will be added to your income, and you have to pay the tax according to your tax slab.

For example, suppose Mr. A comes in a 10% tax bracket. He had invested Rs 1,00,000 in a Debt mutual fund in March 2017. However, he redeemed it in May 2019. Further, his redemption amount was Rs 1,25,000. So, how much tax does he need to pay?

Solution

Capital Gain = Redeemed Amount – Invested Amount

= Rs 1,25,000 – Rs 1,00,000

Thus, the capital gain is Rs 25,000.

Further, Mr. A comes in a 10% tax bracket. Thus, he needs to pay 10% of Rs 25,000. That is Rs 2,500 plus cess or other surcharges. That’s a simple calculation.

Long Term Capital Gain Tax

If you hold a Debt mutual funds units for more than 36 months, then the profit you make on such investments will attract long-term capital gain tax.

It is 20% after indexation. But what is that indexation mean?

What is Indexation?

You know that inflation plays an essential role in profit-making. It erodes the value of assets over time. Thus, indexation helps you consider inflation from the time you bought the asset to the time you sell it. It increases the purchase cost, which results in lesser profits and thus lesser tax.

Thus, investors can benefit from the indexation comparing their capital assets with the Cost Inflation Index or CII in short. Moreover, the Central Board of Direct Taxes or CBDT declares CII every year.

The base year is 2001-02, and the base value is 100. Further, the CBDT has released CII for 2020-21, and it is 301. So, what does it mean?

It means what goods or services you could buy with Rs 100 in 2001-02, you have to pay Rs 301 in 2020-21. 

Thus, it shows how the cost of goods and services is increasing, devaluing your money.

However, the Government of India provides you the facility to adjust your capital gains by inflation. Here is a table for your reference.

Sl. No.Financial YearCost Inflation Index
12001-02100
22002-03105
32003-04109
42004-05113
52005-06117
62006-07122
72007-08129
82008-09137
92009-10148
102010-11167
112011-12184
122012-13200
132013-14220
142014-15240
152015-16254
162016-17264
172017-18272
182018-19280
192019-20289
202020-21301
TABLE 1
The Formula to Calculate Capital Gains using the Indexation Benefit

First, you need to get the Indexed Cost of Acquisition. It is nothing but the inflation-adjusted purchase price.

Indexed Cost of Acquisition = Cost of Purchase * CII of the Year of Redemption / CII of the Year of Purchase

Let’s take an example.

Suppose Mr. x had invested Rs 1,00,000 in May 2004 in a Debt mutual fund. Then he redeemed it in August 2020, and his redemption amount was Rs 3,40,000. Then how much long term capital gain tax does he needs to pay?

Solution

The cost of the purchase was Rs 1,00,000

The redeemed amount was Rs 3,40,000

The CII of 2020 (The Year of Redemption) was 301 (see the table)

The CII of 2004 (The Year of Purchase) was 113 (see the table)

Thus, the Indexed Cost of Acquisition is = 1,00,000 * 301 / 113 = Rs 2,66,372.

Now, Long Term Capital Gain = Redeemed Amount – The Indexed Cost of Acquisition

Thus, It is Rs 73,628 (Rs 3,40,000 – Rs 2,66,372).

He needs to pay 20% long term capital gain tax on the amount. It is Rs 14,726 plus cess.

You can see that his capital gains dropped once we used the concept of indexation. But, what if the year of purchase is before the base year?

The Concept of Fair Market Value

If you have purchased Debt mutual fund units before 2001-02, your Cost of Acquisition becomes either the Actual Cost or the Fair Market Value, whichever is higher.

[Fair Market Value is the price of the units of a mutual fund on 01.04.2001.]

Let’s understand the concept with an example.

Example

Mr. A had bought 10,000 units of a Debt mutual fund at Rs 10 per unit in Apr 1992. The Fair Market Value of a unit of the fund was Rs 18 on 1st April 2001. However, he redeemed his units at Rs 70 per unit in April 2018. How much long term capital gain tax does he need to pay?

Solution

He invested Rs 1,00,000 (Rs 10 * 10,000 units)

The Fair Market Value on 1st Apr 2001 was Rs 1,80,000 (Rs 18 * 10,000 units)

Then we need to choose the higher value between the two and consider it as the cost of acquisition. As the fair market value is higher in the case, we will take it as the cost of acquisition. Thus, his cost of acquisition became Rs 1,80,000 instead of Rs 1,00,000.

Further, the CII of the year of purchase is the CII of the base year, not 1992. But, the CII of the year of redemption remains unchanged.

To get the Indexed Cost of Acquisition, we need to use the formula “The Cost of Purchase * CII of the Year of Redemption / CII of the Year of Purchase.”

= 1,80,000 * 280 / 100

5,04,000 (It is the indexed cost of acquisition)

Further, to calculate the long term capital gain, we need to deduct the indexed cost of acquisition from the redemption amount.

Thus, long term capital gain = Redemption Amount – Indexed Cost of Acquisition

As the redemption cost is Rs 7,00,000 (Rs 70 * 10,000 units), our long term capital gain is as follows.

LTCG = Rs 7,00,000 – Rs 5,04,000 = Rs 1,96,000.

Further, you need to pay 20% on the long term capital gain. Thus, it becomes Rs 39,200 plus cess.

What was his profit?

He invested Rs 1 Lac in 1992, and his redemption value was Rs 7 Lacs in 2018. Thus, his actual long term capital gain was Rs 6 Lacs. However, after the indexation, his taxable capital gain came down to Rs 1.96 Lac only. It is more than a 67% drop in capital gains.

Final Thought on How Debt Mutual Funds are taxed

You observe that long term capital gains come with an added advantage in Equity and Debt mutual funds. For example, the tax you pay in the long term is always lower than the short term one.

Thus, wherever you invest, keep your money to stay for the long term. However, the meaning of the long term differs from asset class to asset class. For example, for an equity mutual fund, it is more than one year. But, for a Debt mutual fund, it is more than three years. There are also other asset classes like commodities and real estate, that we will cover in our subsequent sessions.

So, what should be your plan? Should you redeem your Debt mutual fund units before 36 months if your tax bracket is 5% or 10%?

For me, that may not be the correct decision. To clarify, we invest, keeping in mind a financial goal. If your financial plan is short term, then you can redeem it. But, if your financial goal is a longer one, you should stay in the course. You need not be worried about the tax implications. In addition to that, the indexation benefit is there to minimize your capital gains.

Similarly, if you have kept your emergency fund in Debt mutual funds (that I would suggest), you should not be worried about tax implication because you should remember that tax comes into the picture when you sell it.

Likewise, suppose you have invested in Debt mutual funds to maintain a balance in your portfolio. In such cases, you should not think about taxation as rebalancing your portfolio is more critical than its tax implication. Finally, it depends on you how you will use your money.

Disclaimer

I am neither a tax consultant nor a financial advisor. The post is meant for education purpose only. It is never a recommendation that you need to follow. 

Thanks and regards,

finguru@finlessons.com

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