Debt Mutual Funds Lose Indexation Benefits

In one of the recently proposed changes in the Finance Bill 2023, the tax benefit available on debt mutual funds has been taken away. This has stirred reactions from investors, fund houses as well as the opposition in Parliament.

One of the major arguments emerging out of these reactions is that debt funds are, to an extent, market-linked products. Therefore, income tax on them must be different from what is levied on pure fixed-income investments like bank fixed deposits (FD). Secondly, the government itself invites retail investments in bond index funds for the companies it owns. This amendment will make such funds less attractive to the investor, thus hampering the government’s fund inflow. While this move has further streamlined the tax policies and made them more uniform, stakeholders are bemused by it.

Nevertheless, let us look at the various aspects of the changed scenario around debt mutual funds.

What has changed?

The indexation benefits on long-term capital gains (LTCG) on debt mutual funds will no longer be available after March 31, 2023, i.e., on investments made on or after April 01, 2023. Instead, debt mutual funds will now be taxed at the individual's income tax slab rate. This is applicable for debt mutual funds that invest 35% or less in domestic equity.

Earlier, debt mutual fund investments of over 3 years were treated as long-term capital gains. It was taxed at 20% with indexation benefits. So, if you fall into the 30% tax slab rate, your debt mutual fund capital gain gets taxed at a lower rate, thus giving you tax savings.

Now, such capital gains will be taxed as per your slab rate. So, again, if your slab rate is 30%, you will pay a 30% tax on the capital gain too. Thus, without indexation benefits, debt mutual funds are now like banking and other fixed-income products. No wonder, the indexation benefit was a major attraction for debt mutual fund investors.

The amendment to the Finance Bill 2023 on long-term capital gains is also applicable for gold and foreign equity mutual funds. These are treated as debt funds for taxation and will lose the indexation benefit.

More on Indexation Benefit

Indexation takes inflation into account and results in an increase in your cost of purchase. This reduces the capital profit on the redemption of the debt fund units, thus lowering the tax payable. Applicable tax laws allow the debt fund investor to calculate their income tax liability using the indexed cost of acquisition. It is a normal practice in income tax that acknowledges the existence of inflation in the economy.

To make it simpler

Let’s assume you bought debt mutual fund units for Rs 100 five years ago. That something is now worth slightly more due to inflation. Indexation adjusts the investment amount against the Cost Inflation Index (CII) value of purchases and sales for the fiscal year, lowering the tax burden on investors. As per the CII, 2001-02 is the base year where the index is 100. Five years ago, in 2018-19 it was 280. In 2022-23 it is 331.

So, the indexed cost of acquisition of the debt mutual funds bought five years ago would be – Rs 100 X (331/280) = Rs 118. So, if you redeem them now for Rs 200, your tax will be 20% of Rs (200-118) = Rs 17.6.

But with the recent change, your tax would instead be 30% of Rs (200-100) = Rs 30 (Assuming you fall into the 30% bracket).

Why Was This Amendment Made?

Firstly, debt funds offer predictable returns with almost no credit risk, making them similar to, let’s say, fixed deposits. So, the government doesn’t think it deserves preferential treatment. Do note that these funds do bear interest rate risk and default risk.

Another opinion is that the government is looking to reduce arbitrage. Such an amendment aligns with the new default personal income tax regime that is reducing exemptions and making India's tax policy a simpler and more consistent one with little room for tax exemptions or arbitrage.

Impact on Retail Investors

The end of indexation benefits on debt mutual funds is going to affect investors who invest heavily in debt funds for long-term investments, safe investment options, low risk and tax benefits.

Long-term debt funds may now see more outflows as investors have no tax incentive for retaining it for 3 years. They can redeem investments at any time, book capital gains and pay the tax as per their income tax bracket.

Debt schemes were better than FDs for investors in higher tax brackets. But now the advantage is out of the window. Besides, FD is free of interest rate risk, unlike debt funds. High tax bracket investors may shift from long-term debt funds to equity funds, with sovereign gold bonds, bank fixed deposits, and non-convertible debentures being the other preferred choices in the debt category.

Your Debt Allocation Decision

Some experts feel that debt funds are poised to outperform FDs as the alternatives are not viable enough. Expert fund management, liquidity, and diversification will continue to remain the key strengths of debt mutual funds.

A well-diversified debt fund portfolio will have high regulatory supervision, high disclosure standards, varied liquidity solutions across the duration and credit spectrum, and active and passive options.

As an investor, you must prioritise your risk profile and financial goals. Allocations in asset classes like debt, equity, and gold must align with your financial goals and future cash flow requirements. In other words, tax benefits should not be the sole reason for your investment in debt funds.

Given this amendment, you must avoid herd mentality and panic redemption. Within the mutual fund perimeter, there are other alternatives that investors can consider if they plan to reduce their allocation to debt funds. We have already mentioned that investors may show a greater inclination towards equity funds. Besides, there are hybrid and arbitrage funds that could be two other possible alternatives.

Hybrid mutual funds - Hybrid mutual funds blend equity with fixed-income instruments. They can be further categorized into balanced advantage funds and equity savings funds. Balance advantage funds can have a debt-equity split of anywhere between 0 to 100%. In equity savings funds equity exposure is somewhat restricted between 10 to 50%.

Being categorized as equity funds, they are taxed at 15% in the short term and 10% for long-term capital gain.

Arbitrage funds – Arbitrage funds are low-risk funds with returns comparable to liquid funds. Arbitrage fund managers exploit the price differences of securities in different markets. The advantage of this fund type is that it can shift between asset classes and tap opportunities wherever it arises. Besides, being classified as equity funds, they are taxed in the same manner as hybrid mutual funds.

Together, hybrid and arbitrage funds can also help your portfolio diversify a little more. Hybrid funds can be used for tax-efficient, long-term investing, while arbitrage funds can be utilized for short-term return opportunities.


It would be wrong to assume that the amendments in tax rules for debt funds have no bearing on your investment decisions. With the tax advantage gone, investors will look at debt funds at par with many other fixed-income investment options. The choice thereafter will depend on your financial goals, risk appetite and investment horizon.


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