Don't let tax rate hikes disrupt wealth creation through equity funds

International, gold and silver funds and ETFs will be taxed more favourably from next year

The Union Budget on July 23, 2024, ushered in radical changes in the taxation of mutual funds. Investors must understand their ramifications and modify their investment strategy wherever required.   

Equity funds

Long-term capital gains (LTCG) tax on equity funds increased from 10 per cent to 12.5 per cent in the budget while short-term capital gains (STCG) tax increased from 15 to 20 per cent. “While the 33 per cent increase in STCG tax may seem high, it should not be a concern for investors as equity funds should always be held for the long term,” says Vidya Bala, co-founder, PrimeInvestor.

 

Investors should also view the increase in the LTCG tax rate in conjunction with the increase in capital gains exemption from Rs 1 lakh to Rs 1.25 lakh, which will provide some relief.

Suppose that a person earns 12 per cent pre-tax return on an equity fund. Earlier, her post-tax return with 10 per cent LTCG tax would have been 10.8 per cent. Under the proposed tax rate of 12.5 per cent, her post-tax return will be 10.5 per cent. The differential in post-tax return at the end of the first year is 0.3 percentage points. “The post-tax return differential reduces over time. After 10 years, it decreases to 0.2 percentage points and after 20 years even further to 0.14 percentage points,” says Bala.

The change in the LTCG rate should not be regarded as a major deterrent to investing in equity mutual funds. “Investors should simply pare their post-tax return expectations and carry on since there can anyway be no respite from this tax increase,” says Arvind A Rao, founder, Arvind Rao and Associates.  

Debt mutual funds

The government did not announce an increase in market borrowings over the amount mentioned in the interim budget. It is also faring better than expected vis-a-vis its fiscal deficit target. These, according to experts, are positives for bond mutual funds.  

“Quicker than expected fiscal consolidation, high quality of budget spend, narrowing of primary deficit, and focus on positive credit environment by extending credit guarantee to MSMEs (Micro, Small & Medium Enterprises) are measures that are supportive of lower inflation and improved macro fundamentals. They will further help the cause of lower interest rates. In that context, longer duration funds appear slightly more attractive on a relative basis,” says Mahendra Kumar Jajoo, chief investment officer-fixed income, Mirae Asset Investment Managers (India).

Definition of specified mutual funds changed

The taxation of debt mutual funds changed from April 1, 2023. To facilitate this change, the government brought in Section 50AA and created a category called “specified mutual funds”. These were defined as funds having an investment of less than 35 per cent in domestic equities. Both indexation benefit and the concept of long- and short-term capital gain were taken away from them and they were taxed at slab rates.

“However, gold funds and exchange-traded funds (ETFs) and foreign funds and ETFs, which had less than 35 per cent exposure to domestic equities, also came to be taxed at slab rate, just like debt funds,” says Deepesh Raghaw, a Sebi registered investment advisor (RIA).

In the July 23 budget, the definition of specified mutual funds was changed to funds that have 65 per cent or more exposure to debt and money market instruments. “Only pure debt funds, a debt-oriented conservative hybrid fund, or a debt oriented fund-of-fund having 65 per cent or more in debt will be taxed at slab rate,” says Bala.

After this change, gold funds and ETFs and foreign equity funds and ETFs will not fall in the category of specified mutual funds. Gold ETFs, for instance, will be taxed on LTCG at 12.5 per cent after 12 months.  Note that this change will only come into force from the next financial year.

With this change, the taxation of foreign equity funds will improve. “Investors must consider a decent allocation to foreign funds for geographic diversification. Allocating to them had become difficult when they were being taxed at slab rate,” says Raghaw.

An anomaly

The recent changes have given rise to an anomaly. Gold funds will qualify for LTCG tax treatment after 24 months. On the other hand, gold ETFs will qualify for LTCG after 12 months. “This has created an unintended arbitrage between the two instruments. Why will people invest in gold funds, where they will get long-term capital gains treatment after 24 months when they can get it after 12 months in gold ETFs,” says Bala. The same anomaly will exist in the case of international and silver fund of funds versus ETFs.

Three categories of funds

Hereafter, the following basic rules of taxation will apply. “One, funds with more than 65 per cent in debt instruments will be classified as specified mutual funds under Section 50AA and taxed at slab rate. Two, funds with less than 65 per cent in debt will get LTCG tax treatment and be taxed at 12.5 per cent after 24 months. Equity-oriented funds with more than 65 per cent in equities will be taxed at 12.5 per cent after 12 months,” says Bala.

Hybrid funds that hold between 35 and 65 per cent equities were earlier taxed at 20 per cent with indexation on LTCG. “They have lost the indexation benefit now,” says Rao. They will be taxed according to the rules mentioned above. 

Key takeaways for MF investors

> LTCG tax on equity funds increased from 10% to 12.5%; STCG tax from 15% to 20%; capital gains exemption threshold increased from Rs 1 lakh to Rs 1.25 lakh

> Adjust your post-tax return expectations and continue investing in equity MFs

> From April 1, 2023, specified mutual funds, defined as having less than 35% in domestic equities, were taxed at slab rates

> The new definition, which comes into force from next year, says specified mutual funds will be those having 65% or more in debt and money market instruments

> Gold funds and ETFs, and foreign equity funds and ETFs will be taxed more favourably from next year