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Debt Mutual Fund Taxation 2021

Debt Funds Taxation - Overview

Last Updated 13th May 2021

  • A debt mutual fund is an investment in which the core holdings comprise fixed-income investments.
  • Debt mutual funds are categorized as short term and long term capital gains tax.
  • Short term capital gains on debt holding for less than one year is taxed at the same rate as your ordinary income under section 111A.
  • Long term capital gains on debt holding for more than one year considers indexation and is taxed at 20% for resident Indians under section 10 (38).
INCOME TAX CALCULATOR

Taxation on Debt Mutual funds under section 10(35)

There are two categories of taxation applicable on debt mutual funds:

Type of Tax Tax rate
Short Term Capital Gains Tax
Resident Indian As per individual’s income tax bracket
Non Resident Indian As per individual’s income tax bracket
Long Term Capital Gains Tax (under section 112)
Resident Indian 20% (with indexation benefit)
Non Resident Indian On listed funds- 20% (with indexation benefit) On unlisted funds- 10% (without indexation benefit)
Dividend Distribution Tax (DDT) At the rate of 28.84% (including surcharge and cess) for individuals and HUF(under section 115R)

What are Debt Mutual Funds?

Debt mutual fund is a type of mutual fund scheme in which a significant proportion of assets under management is principally invested in fixed income securities including bonds and debentures. They fall in the category of “Non Equity Mutual Funds” that are defined as funds with less than 65% of their portfolio invested in equity and equity related instruments. All mutual funds, including debt mutual funds, balanced funds, gold funds, money market funds etc are categorized as non equity mutual funds.

Example - liquid mutual funds, money market funds, gold funds, infrastructure debt funds (debt oriented)

How is capital gains tax computed on debt mutual funds?

Capital gains arising on sale of debt mutual funds attract capital gains tax. The sale will attract short term capital gain tax or long term capital gain tax depending on the holding period.

  • Long term capital gains- If you sell your investment in a debt mutual fund after 3 years of holding period, capital gains arising from such transaction is classified as a long term capital gain (LTCG) and will be taxed at long term capital gains tax rate. Long term capital gains is eligible for indexation benefit in which cost of acquisition of an asset is adjusted for changes in cost inflation index during the holding period. In case of an increase in the index, the cost of acquisition is adjusted upwards, thus reducing the quantum of capital gain and hence, capital gains tax. The price indices used for the adjustment are maintained and released by Income tax department.
  • Short term capital gains- If you sell your investment in a debt mutual fund in less than 36 months (3 years), capital gains arising from the transaction is classified as a short term capital gain (STCG) and will be taxed at short term capital gains tax rate.

Illustration 1: Calculation of capital gains tax in case you sell a debt mutual fund after 3 years of holding

Mr. A, an Indian resident, sells his investment in debt mutual fund at ₹ 15,000 on 20th March 2017. He had purchased the scheme ₹ 10,000 on 10th March 2014. What will be his capital gains tax liability? Mr. A earns a capital gain of ₹ 5,000 on his sale transaction. Since his holding period is more than 3 years, he is liable to pay capital gains tax rate of 20% and is also eligible for indexation benefit.

Cost Inflation Index for 2016-2017 is 1125 and was 939 in 2013-2014 when the scheme was purchased. After applying the change in Cost Inflation Index (10,000*1125/939), the indexed cost of acquisition stands at ₹ 11,981. His capital gain is ₹ 3,019 (Sale proceeds less indexed cost of acquisition). At a rate of 20 %, Mr. A is liable to pay a tax of ₹ 604 as capital gains tax on the sale of his debt mutual fund.

Computation of Capital Gains Tax
Sale proceeds of debt mutual fund (1) 15,000
Cost of Acquisition (2) 10,000
Indexed Cost of Acquisition (3) 11,981
Long Term Capital Gains (4)= (1)-(3) 3,019
Long Term Capital Gains rate @20% (4)%20% 604

Illustration 2: Calculation of capital gains tax in case you sell a debt mutual fund before 3 years of holding

Mr. B, an Indian Resident, sells his investment in debt mutual funds at ₹ 10,000 on 25th March, 2017. He had purchased the scheme at ₹ 5,000 on 15th March, 2016. Mr. B falls under the marginal tax rate category of 25%. What is his capital gains tax liability?

Since Mr. B’s holding period is less than 3 years, he is liable to pay short capital gains tax on the capital gains arising from the sale at the rate of 25% (marginal tax rate slab applicable to him). Mr. B earns a capital gain of ₹ 5,000 on his sale transaction Applying a tax rate of 25%, he is liable to pay a capital gains tax of ₹ 1,250 on his capital gains of ₹ 5,000 (5,000* 25%)

Indexation benefit refers to the adjustment of cost of acquisition of an asset for changes in cost inflation index during the holding period. In case of rise in cost inflation index, this adjustment would increase the cost of acquisition, thus reducing the quantum of capital gain and hence, capital gains tax. The cost inflation index for every year used for the adjustment is maintained and released by Income Tax department. The indexation benefit is available only on transactions that qualify for long term capital gains under Income Tax Act.

How much dividend distribution tax (DDT) is charged on debt mutual funds?

Any distribution of income on debt mutual funds is subject to a dividend distribution tax at the rate of 28.33% (including surcharge and cess) for Individuals and HUF investors. Asset management companies deduct DDT from dividend before crediting dividend in the account of debt mutual fund holders.

FAQs

Is debt mutual fund tax-free?

No, debt mutual funds are not tax-free. The tax charged on debt mutual funds is based on the short term and long term capital gains.

Is Debt fund better than FD?

Debt fund and fixed deposit offer high returns with low risk on investment. Some of the common differences between FD and debt funds are:

  • Tenure: FDs are for a fixed duration of time while there is no such fixed duration on a debt fund.
  • Liquidity: Debt funds have high liquidity as compared to fixed deposits since they can be redeemed at any point.
  • Volatile: Returns are volatile on debt while fixed in FDs.

How do you calculate tax on debt funds?

Long-term capital gains on debt funds are taxable at the rate of 20% after indexation. While an individual is required to add short-term gains from debt funds to his overall income. They are subject to short-term capital gains tax and are taxable according to the income tax slab.

How do private debt funds work?

Private debt involves the lending activity done by entities other than banks. This can include lending by more specialised entities or Peer to Peer lending.

Why is debt better than equity?

Debt is considered better than equity because of the following reasons:

  • Debt does not dilute the owner's ownership interest in the company.
  • Interest on the debt can be deducted from the income tax.
  • Raising debt capital is less complicated.
  • A lender has no direct claim on future profits of the business.

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