Taxation of Debt Funds

Taxation on debt funds varies depending on the different types of funds. Short-term investments (less than 3 years) differs from long-term investments (more than 3 years). Returns can be income as interest or capital appreciation or depreciation.

Mutual Funds is one of the latest and the most progressive investment tools in the Indian market currently. Mutual funds are basically segregated further into various types depending upon the nature of Investment Avenue they invest in. Debt funds are a type of mutual fund that invest their capital into debt instruments or fixed income securities like Treasury Bills, Corporate Bonds, Government Securities, and Money Market Instruments etc.

Debt Funds are considered safer than funds that invest in equities. This is because they invest in avenues that generally offer a fixed rate of return and have a fixed date of maturity and are not linked tightly to the movement of the stock market.

Returns obtained on a Debt Fund:

Debt fund generally yield lower returns as compared to the more aggressive investment tool, Equity Funds. However, returns reaped on Debt Funds are mostly fixed.

Returns realized on Debt Funds can be clubbed under two different heads:

  • Income received as interest
  • Capital appreciation or depreciation in the value of fund based on changes in market dynamics

Debt Funds have several sub-types of funds which are again segregated based on the segment in which they make their investment. Some of the most well-known Debt Funds are Liquid Funds, Ultra Short Term Funds, Floating Rate Funds and Corporate Bond Funds

Depending upon the type of fund, the taxation process of these funds varies. Let us look into the tax liabilities that arise as a result of holding any of these Debt Funds.

Tax on Debt Funds:

Debt Funds are liable to be charged two types of taxes depending upon the period for which they are held. These two types are the Short-term Capital Gain tax and the Long-term Capital Gain tax.

Debt Fund held for less than 3 years is put under Short-Term Investment:

The tax on Debt Fund held for less than 3 years is calculated as per the income tax bracket for that individual. For Example, Sunil is an IT Executive who earns Rs.10,00,000 per annum. According to the latest tax slabs for the year 2016-17, Sunil falls in the tax bracket of 20%. Sunil had invested Rs.1,00,000 in Debt Fund from ICICI for a period of 2years. Since this fund is held for less than 3 years, the returns earned on this instrument will fall under short-term capital gains and will be taxed as per the Income Tax bracket in which Sunil falls, that is 20%.

Suppose Sunil earned a return of Rs.10,000 on this debt fund, then according to his tax bracket, he will have to pay 20% of Rs.10,000 as interest which comes down to Rs.2000

Debt Fund held for more than 3 years is put under Long-Term Investment:

Any interest earned on debt funds that are held for more than 3 years is counted under Long-Term Capital Gain. The applicable taxation rate in this case is 20% with indexation plus 3% cess which comes down to 20.90%.

For example: Sunil is an employee in the IT sector. He earns a salary of Rs.15,00,000 per annum and has invested in a debt fund of Rs.2,00,000 for 5 years. As per the latest tax norms, his debt fund comes under the definition of long term capital gains and is eligible for a tax deduction of 20% with indexation plus 3% cess on the returns earned.

The total outstanding tax that Sunil needs to pay on returns earned on his debt fund is 20.90%.

NOTE: Calculation of tax on returns from debt funds held for periods shorter than 3 years is independent of indexation. Calculation of tax on returns from debt funds held for more than 3 years takes into account indexation.

Indexation is the process of taking into account the rate of inflation by employing a price index which adjusts inflation. Indexations accounts for the change in inflation from the time you buy your asset to the time you sell it. The cost inflation index number is released each year by the central tax authorities.

Debt Funds or Fixed Deposits?

Since debt funds and fixed deposits are comparable investment tools with respect to the rate of interest they offer and the low-risk associated with them, there is always a certain dilemma among customers regarding which one to choose.

However, debt funds held for long term take into account inflation whereas fixed deposits total your interest income and then tax it accordingly. And hence, the overall return earned on debt funds is generally higher than that earned on fixed deposit instruments despite the higher rate of interest that FDs offer.

Another significant point to be noted is that investors who lie in the higher tax bracket of 20-30% stand to gain more from tax-efficient debt funds than those who are in the lower bracket of 10% and as such do not profit from indexation.

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