TAX EFFICIENCY OF DEBT MUTUAL FUND

 Capital gains realized in debt oriented mutual fund schemes are eligible for indexation benefits if it is long term capital gain. If an investor held the investment in debt oriented mutual fund scheme more than three years such investment is known as long term investment and gain arises from such investment is long term capital gain and if the investor holding period is less than three year it is considered a short term capital gain, which is added to the income of investor for tax calculation and indexation benefits cannot be claimed. All categories of debt mutual fund scheme be it active or passive are eligible for indexation benefit. other fixed income products like bank deposits and post office savings schemes are not eligible for indexation benefits and investor have to pay tax in line with their tax slab.

Indexation is a process of using which one can account for inflation in the gains made in debt funds to reduce the tax outgo.this method helps in giving investor post tax returns which are above inflation, indexation is done through a mechanism that uses the cost inflation index which adjust the purchase price of an asset for inflation in the year of its sale.

Every financial year, the government and central board of direct taxes (CBDT) declare a cost inflation index (CII). From the year in which you purchase your debt mutual funds, the purchase cost is indexed for each financial year till you remain invested, the capital gains for taxation purposes, are computed as sale price or redemption price minus the indexed cost of acquisition.

For example you invested in a debt fund on September 1,2016 at an nav of rs.10 you redeemed the fund december 10, 2021 at an nav rs 14. you are eligible for indexation as you have been invested for more than three years, The CII for FY17 is 264 and that for FY22 is 317, Hence your purchase cost is indexed up to 317/264 X rs 10= 12. Hence your capital gain for the purpose of taxation is 14-12=rs 2. Now as per tax rules, the rate of long term capital gains tax on debt funds is 20% using indexation. the tax payable is rs 2 X 20% = rs. .40. Thus on a capital gain of rs.4, the effective tax paid by an investor is rs.0.4, which comes to a rate of 10% , which score significantly well when compared to fixed deposits where investor in high tax brackets would pay 30% plus surcharge.

Source: Economic Times .