The Dichotomy Between Taxation Of Bond And Bond Mutual Funds

Holding period for LTCG eligibility is one year for bonds and three years for bond funds.

We have discussed previously, the rules of taxation for bond and bond mutual funds. To recap, in bonds, the coupons i.e. interest payments are taxable at your marginal slab rate. For most investors, the marginal slab rate is 30% plus surcharge and cess. Capital gains, which occur when you sell your bond at a price higher than your purchase price, is taxable at a defined rate. The rate is 10% plus surcharge and cess, when you sell the bond after holding it for at least a year, provided the bond is listed at the stock exchange. The holding period of one year makes it taxable as Long Term Capital Gains (LTCG). Obviously, 10% is a relatively lower rate than the marginal tax bracket of most investors.

In debt mutual funds, the holding period required is three years, for eligibility for LTCG taxation. If the holding period is less than three years in debt mutual funds, it is Short Term Capital Gains (STCG), 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 reduces the taxation significantly.
In other words, for tax efficiency, you have to hold your debt funds for more than three years.

For clarity, the benefit of indexation is not available in bonds. There is a mistaken notion in some sections, that indexation is available in bonds. This may possibly emanate from the fact that it is available in debt funds and there is a resemblance 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 are widespread discussions that in the forthcoming union budget, to be presented on 1 February, the finance ministry is considering bringing about uniformity in taxation of capital gains. Currently, the holding period required 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 a lopsided message from the authorities that the holding period for equity funds should ideally be one year and three years for debt funds. Given the volatility of equity and debt as asset classes, it should be the other way round.

The dichotomy between taxation of bonds and bond funds is that the holding period required for eligibility 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 for bringing the two on the same platform. It can be done either by decreasing the holding period required for mutual funds, or increasing the period for bonds, or meeting halfway. If the holding period for LTCG for debt funds is reduced to, say, two years, it would incentivize people to come into debt funds and encourage the vehicle.

The other aspect the finance ministry may consider is according the benefit of indexation to bonds. If so, the holding period requirement for LTCG may be increased from the current one year. The tax revenue impact for the government would not be much, as most of the returns from bond investments come from the coupon (interest) and only a small bit from capital gains, if at all it is sold prior to maturity, at a profit. Bonds being an important source of raising resources for corporate India, next to equity, it needs to be incentivized, at least to some extent.

For investors, there is no action point prior to the union budget. If there is any change in taxation rules for bond or bond funds announced on 1 February 2023, the other variable is the applicable date. If there is a grandfathering clause i.e. it is made applicable only to fresh investments after a cut-off date, then your existing investments would be taxed as it is done currently. If status quo is maintained in the union budget, then tax efficiency can be achieved by investors through the MF route, provided the investment horizon is at least three years.

The beauty of debt mutual funds, from the tax perspective, is that all inflows, including the coupon inflows, effectively get taxed at the efficient rate.


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