How are Debt Funds Taxed & Indexation Benefit: Updated Rules (2020)

As people continue to look for safe higher than fixed deposit returns in India, there is a growing interest in a type of mutual fund: the Debt Funds.

I have already written in detail about various types of Debt Funds earlier.

So in this article, let’s have an in-depth look at how the Debt Funds are taxed in India and what is the role of indexation in the taxation of debt funds.

Depending on your investment horizon (or holding period) in debt funds, the capital gains are of 2 types:

  1. Short Term Capital Gains (STCG) or
  2. Long Term Capital Gains (LTCG)

What are these and how are the long and short term decided?

Short Term Capital Gains in Debt Funds

  • Gains made on investment in Debt Mutual Funds held for less than 3 years (or 36 months) are classified as Short Term Capital Gains.

Long Term Capital Gains on Debt Funds

  • Gains made on investment in Debt Mutual Funds held for more than 3 years (or 36 months) is classified as Long Term Capital Gains.

And from a taxation perspective, all mutual fund schemes that invest less than 65% in equity and equity-related instruments are treated as Debt funds (or Non-Equity Funds). For Example: Liquid funds, Ultra Short Duration Funds, Short Duration Funds, Low Duration funds, Money Market funds, Conservative Hybrid funds, etc.

Now let’s see how exactly are these long-term capital gains and short-term capital gains are taxed in debt mutual funds.

Debt Funds Capital Gains Taxation (Latest Rates)

As per the latest Mutual Funds Capital Gains Taxation Rules (FY 2019-2020):

  • Short Term Capital Gains (or STCG) on Debt funds are taxed as per the investor’s marginal income tax slab rate.
  • Long Term Capital Gains (or LTCG) on Debt funds is taxed at 20% with indexation benefits.

Now, what is this indexation benefit that is available for taxation of LTCG from Debt Funds? Let’s see this in detail:

Indexation Benefit for Taxation of Debt Funds Capital Gains

To put it very simply, indexation is a way to adjust capital gains as per the prevailing inflation index. This helps lower overall liability to pay taxes by inflating the purchase cost, thereby reducing the effective capital gains.

And in mutual funds, this advantage of indexation is available only for long term capital gains made on the debt funds.

Here is a small example to understand this concept.

And be reminded that the gains made on investment in debt mutual funds held for more than 36 months are considered LTCG (Long Term Capital Gains) and indexation benefit is available on it

Suppose you invested Rs 10 lac in a good debt fund in July 2015. After a little more than 4 years, i.e. in November 2019, the value of your debt fund investments has become Rs 14 lac.

Assume you sell it at this point.

So mathematically speaking, you made capital gains of Rs 4 lac. But this gain was made after a period of 4 years, which is more than 3 years requirement for capital gains qualifying as Long Term Capital Gains for Debt Funds.

So do you pay tax on this full Rs 4 lac gain at the time of selling?

No.

Because as per the latest taxation rules of mutual funds, the Long Term Capital Gains on Debt Mutual Funds are taxed at 20% after indexation.

This means you need to adjust the cost of acquisition of debt fund units for indexation first. And for that, the following numbers are known:

  • Cost of acquisition = Rs 10 lac
  • CII number for 2015-16, the year of purchase = 254
  • CII number for 2019-20, the year of sale = 289

So the indexed cost price of acquisition is calculated using the formula:

Indexed Cost = Actual Cost * (CII of Sale Year / CII of Purchase Year)

And in our example, this comes out as follows:

= Rs 10 lac * (289/254) = Rs 11,37,795

And this means that the long term capital gains is calculated as follows:

= Rs 14,00,000 – Rs 11,37,795 = Rs 2,62,204 (Rs 2.62 lac)

So you get taxed at 20% on this amount of Rs 2.62 lac (instead of Rs 4 lac without indexation). And this translates to:

LTCG tax of 20% on Rs 2.62 lac, i.e. Rs 52,400 (approx.)

Had it not been for indexation benefit, your tax would have been 20% on full actual profit of Rs 4 lac: 20% of Rs 2 lac = Rs 80,000.

To summarize, the purchase price of debt fund (investment price) is multiplied by the CII for the year in which the sale is made and divided by the CII for the year in which the purchase was made. The indexed price so arrived at is used to calculate the capital gains on which LTCG tax of 20% plus surcharge and cess, etc. are applicable.

So indexation helps reduce your tax obligations considerably. And this is one of the things that makes debt funds very attractive. Their tax efficiency.

If you want to know more about the Cost Inflation Index (CII), then read latest Cost Inflation Index (CII) for current financial year. To indexation benefit, you need to be aware of the CII number in the year of purchase and the year of sale of debt fund units. The CII Index is updated for each financial year and is also available on the income tax website.

The best part is that the adjustment of the purchase price in Debt Funds (to accommodate indexation) is done just for calculating the tax on capital gains and doesn’t actually reduce the actual gains or profit you made on your debt fund investments.

And I am sure you would have realized by now that if the inflation is high in the period between the purchase and sale of debt funds, then the indexed cost of acquisition of debt fund investments will go up, thereby reducing the gains that are liable for taxation.

So this is how tax is calculated on debt mutual fund capital gains.

And since indexation benefits are available on debt mutual funds, it makes them more tax-efficient than bank Fixed Deposits. And this gives debt funds a big edge over bank deposits in terms of post-tax returns. Unlike debt funds where the capital gains are taxed only at the time of sale and too with indexation benefits, the interest income on bank FDs is added to the total income and taxed as per the income tax slab applicable to the investor (more on FD interest taxation in India)

How is Long Term Capital Gains from Debt Fund SIP taxed?

The concept and rules remain the same.

The only thing to understand is that each SIP instalment in Debt Fund is considered as a new investment. Hence, each SIP instalment will have its own unique holding period for the calculation of whether the gains are STCG or LTCG.

So each SIP instalment you do, is treated as a new investment and attracts taxes on its gains separately.

And that is all there is to know about the latest Debt Fund Capital Gains taxation rules in India (2020).

But did we miss something?

Yes.

What about the taxation of dividends from Debt Funds (if any)?

Debt Funds Dividend Taxation (Latest Rates)

Dividend Distribution Tax (or DDT) is deducted and paid by fund houses, before they pay the dividends to investors. So dividends at the hand of investors is tax-free. And how much is the DDT being paid. The rates are different for equity and debt funds:

  • Tax on Dividends from Debt Funds: Fund houses pay 25% Dividend Distribution Taxor DDT (which becomes about 29.12% inclusive of 12% surcharge & 4% cess) on debt mutual fund schemes

That’s it.

Debt Funds are part of overall mutual fund space which also has equity funds in it. To know more about all aspects of taxation for mutual funds, please refer to this detailed Tax Reckoner for Investments in Mutual Fund Schemes in India 2020 where I try to answer all your questions about Mutual fund taxation and latest income tax rules on gains from Mutual Funds in India.

Hopefully, this detailed post on what are the latest taxation rules of debt funds and how to calculate your tax liability in Debt Mutual Funds with indexation, does help you better understand the taxation of your debt fund investments in India in 2020-21.

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