What tax benefit do debt mutual funds enjoy?
Capital gains realised in debt-oriented mutual fund schemes are eligible for indexation benefits if the investor has held them for more than three years. If the holding period is less than three years, it is considered a short-term capital gain, which is added to the income of the investor for tax calculation and indexation benefits cannot be claimed. All categories of debt-oriented funds, be it active or passive, are eligible for indexation benefit. Other fixed income products like bank deposits and post office savings schemes are not eligible for indexation benefits and investors have to pay tax in line with their tax slab. So, for example, an investor in the 30% tax bracket will have to pay 30% tax on his interest income from fixed deposits.
What is indexation?
Indexation is a process using which one can account for inflation in the gains made in debt funds to reduce the tax outgo. This method helps in giving investors post tax returns, which are above inflation. Indexation is done through a mechanism that uses the cost inflation index (CII), which adjusts the purchase price of an asset for inflation in the year of its sale.
How does it work?
Every financial year, the government and the Central Board of Direct Taxes (CBDT) declare a cost inflation index (CII). From the year in which you purchase your debt mutual funds, the purchase cost is indexed for each financial year till you remain invested. The capital gains, for taxation purposes, are computed as sale price or redemption price minus the indexed cost of acquisition. Let’s say you invested in a debt fund on September 1, 2016, at an NAV of Rs 10. You redeemed the fund on December 10, 2021, and then NAV was Rs 14. You are eligible for indexation as you have been invested for more than three years. The CII for FY17 is 264 and that for FY22 is 317. Hence your purchase cost is indexed up to 317/264 X Rs 10 = Rs 12.0. Hence your capital gains, for the purpose of taxation, is Rs 14 minus Rs 12 = Rs 2. Now as per tax rules, the rate of long-term capital gains tax on debt funds is 20% using indexation. The tax payable is Rs 2 X 20% = Rs 0.40. Thus on a capital gain of Rs 4, the effective tax paid by an investor is Rs 0.4, which comes to a rate of 10%, which scores significantly well when compared to fixed deposits where investors in high tax brackets would pay 30% plus surcharge.
