Saturday, March 25, 2023

Change in tax rules on debt investments

Starting April 1, 2023, investments in debt funds will no longer be eligible for indexation benefit on Long Term Capital Gains. 

A small tweak, in small print, in the budget. The government proposes, and the government disposes! But the implications for the investors are quite big.

But it is not easy to understand what this means. Understanding that one sentence above presupposes a knowledge of tax laws and of investment options in financial markets.

So, a small primer on the required essentials first. 

1. You have broadly four kinds of investment options ( there are more but these are the primary ones). Equity, debt, real estate, and gold. They are called asset classes. Each of these carries a different risk-return profile.

2. For each of the above asset classes, you can choose to invest either directly or through mutual funds. 

3. Debt mutual funds are mutual funds that invest in debt paper of various kinds, like debentures of companies, bonds, treasury bills, government securities,  deposits, certificates of deposits, money market instruments... The names are many, and confusing, but essentially debt MF's invest in debt paper of the government or of  various companies or financial institutions. They earn interest on their investments and get their principal back on maturity ( hopefully). All these investments are of the form where they can be bought and sold in the secondary market to other investors, meaning they don't have to wait for the redemption date to get money, someone else is always available to buy the debt paper from you.

4. All investors pay income tax on their income. The tax is based on a slab rate from zero to thirty percent. Income consists of whatever you earn, including interest on your debt investments and dividends on your equity investments, and of course your salary, pension, etc. 

5. What about when you invest in equity shares or land? When you sell them you make a profit ( or loss) . Let's say you buy equity shares of Infosys for one lakh rupees and hold them for seven years. Or buy a piece of land and hold it for 7 years. You get dividends on the  shares every year and nothing on the land of course. The annual dividends  are part of your annual income, and they are just added to your income on which you pay tax.  Let's say you sell the shares, or the land,  after seven years for six lakh rupees.  You have made a "capital gain" of five lakhs. How is this taxed? 

If it is "short term" capital gain, meaning you held the investment for less than one year in case of equity and two years in case of land, the sale price minus purchase price, in other words, the gain of five lakhs is just added to your income for the year, on which income you pay tax.

If it is long term capital gain, you pay tax as follows: 

a) Your purchase price of one lakh is "indexed" upwards based on the  inflation in those seven years that you held the investment, based on an "income tax indexation table". Thus your one lakh becomes, say, one lakh eighty thousand.

b) your capital gain on sale is sale price less indexed purchase price, which is six lakhs minus one lakh eighty thousand, which is four lakh twenty thousand. You pay tax at the flat rate of twenty percent of that, and your tax works out to 84000.

6. All investments in mutual fund units are considered "capital " investments, like the investments in Infosys shares or land above. On sale, they are taxed as per the procedure explained in Point 5.

7. To determine whether the gains are long term or short term, in case of equity mutual funds, the cutoff is one year. In case of debt mutual funds, the cutoff is three years. 

Ok, now let's talk about the amendment to the tax law that is effective from April 1, 2023. Go back and read the first sentence of this article. The special tax treatment for long term capital gains on investments in debt mutual funds will no longer be applicable. In other words, when you sell units of your debt fund, your gain, that is sale price minus purchase price, will just be added to your income for the year, and taxed accordingly. 

Still confused? Don't blame yourself, blame the tax laws, they are designed to befuddle us and create a state of brain freeze. Just go back and read the whole thing again. 

Ok, you went back and read the whole thing again. Or you called your  friend the CA and regretted it, for now you are even more confused. I know very few CA's who can explain things to the layman, forget that, they can't even explain things to each other! 

In any case, you read it again , and now you think you understand what I am talking about. 

The next obvious question is, what is the implication for you? 

We will save that for the next article, coming up soon. 

Now, go and have that coffee, or that stiff peg of whiskey, you need it. Reading about tax is always taxing.

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