Inflows in debt funds continue despite the removal of indexation benefits, which was more of a psychological shock than hard fact.

When the Finance Act 2023 took away the indexation benefit from taxation of debt mutual funds, it was initially considered a big jolt. When something that we are used to is taken away, our reaction is adverse. Then, we get used to the change.

The Finance Act stated that mutual fund schemes with less than 35 percent allocation to equity – essentially debt funds – and a few other fund categories will be taxed as short-term capital gains, irrespective of the holding period. The dividend option of funds, which is called income distribution cum capital withdrawal option, was anyway taxable at the marginal slab rate of the investor.

For investments from April 1 this year, the growth option of debt funds has been made taxable at the marginal slab rate of the investor. Earlier, for investments made till March 31 and a holding period of three years or more in the growth option of a debt fund, the tax rate was 20 percent after indexation.
Indexation effectively lowered the tax rate significantly. It was felt that without this taxation advantage, fresh investments in debt funds would be adversely impacted.

Money still coming

Although the Finance Bill was tabled on February 1, the changes in debt fund taxation were introduced only in the second-last week of March, just before the passage of the bill.

Debt funds in the usual categories, apart from Fixed Maturity Plans and Target Maturity Funds, managed assets of Rs 12.3 lakh crore on February 28. The average assets managed in the month of February were Rs 13.03 lakh crore.

Comparatively, assets managed by debt funds were Rs 14.17 lakh crore on July 31, with the average for the month at Rs 14.56 lakh crore.

The increase in money managed by the debt funds shows that tax efficiency is not the only criterion for allocation.

Prior to the taxation changes, more than 60 percent of the assets of debt funds were in portfolios with a maturity of up to one year. While there is no issue in holding a money market or very short maturity fund for a long horizon, these funds are not meant to be held for three years.

There are other debt fund categories with a relatively higher portfolio maturity that are meant for an investment horizon of three years or longer. The point is when the taxation changes hit us, it was more of a psychological impact than hard fact. The bulk of the money was anyways in shorter maturity products.

Debt investment parity

From the taxation perspective, debt mutual funds are now more or less at par with other fixed-income investment avenues. Interest on fixed (term) deposits are taxable as income from other sources, at your marginal slab rate. Debt MFs are also taxable at the marginal slab rate, with a small additional benefit: it is possible to set-off short-term capital losses, if you have any.

Direct bond coupons are taxable at the marginal slab rate; capital gains, if any, are taxable at a relatively lower rate. Taxation of portfolio management services is a pass-through, i.e., as if you hold the securities directly and not through an investment vehicle.

Alternative Investment Funds category I and II are pass-throughs for taxation; in category III, there is tax deduction at source at the highest marginal rate, including surcharge and cess.

The rationale

The basis for any portfolio allocation is your investment objective, time horizon and risk appetite. Debt allocation is relatively less volatile than equity and gold. Depending on your risk appetite, you can make appropriate allocations to debt.

Moreover, there is the option of laddering, or generating cash flows to match your requirements by investing the proceeds in a series of debt investments with varying maturity periods.

Thereby, you effectively eliminate market fluctuations when you require cash.

Not to forget, in your systematic investment plans, to the extent appropriate for your portfolio, debt should also have an allocation.

Source: https://www.moneycontrol.com/news/business/personal-finance/debt-funds-still-work-even-without-indexation-benefits-11285331.html