Taxation helps to raise revenues and is also a useful mechanism to address inequality. But this year, New Delhi has used taxation to distort the asset allocation of investors. The move will have wider implications for the investing community and reconfigure the dynamics of the banking industry.
The subject matter is the taxation of investment in debt mutual fund units. As per the amendments to the Finance Bill, 2023, any investment in debt mutual fund units (where equity investment is up to 35%) on or after April 1, 2023, will not get the benefit of indexation on long-term capital gains. This means that investments made in these debt funds up to March 31 only will get the benefit of the existing LTCG taxation regime.
Indexation reduces the overall tax liability of an investor by adjusting the purchase price of the underlying asset or investment. This helps an investor to realise higher gains, since it allows the adjustment of gains against the rate of inflation of the year of purchase and sale. The rate of inflation used for indexation is obtained from the Cost Inflation Index (CII). The Union government determines the values in the index and is updated on the website of the Income Tax Department.
How to calculate the indexed cost of acquisition of an asset (ICoA)?
ICoA = original cost of acquisition * (CII of the year of sale/CII of year of purchase).
An example: You invested Rs 2 lakhs in a debt fund in August 2014 (20,000 units @ Rs 10 each). You redeemed your investments in July 2020 at a value of Rs 3,00,000 ( 20,000 units @ Rs 15 each). Your investment made capital gains of Rs 1,00,000. If you have the benefit of indexation, you need not pay tax on this entire amount of Rs 1,00,000.
All you need to do is apply the formula.
- Cost of acquisition is Rs 2 lakh.
- CII number for purchase year (2014-15) was 240.
- CII during the sale year (2020-21) was 301.
This would mean that your indexed cost of acquisition would be (2,00,000 * 301/240) = Rs 2,50,833. Your long-term capital gains would come down to Rs 49,167 (Rs 3,00,000 – Rs 2,50,833). You will be taxed 20% of this amount (not Rs 1,00,000 without indexation).
The intention behind doing away with the benefit of indexation on long-term capital gains appears to be to tax the gains arising on transfer, redemption or maturity of such debt mutual fund units in the same manner as interest income from bank fixed deposits, at normal slab rates.
The ostensible objective is to erase tax arbitrage arising out of differential treatment of assorted asset classes. Ushering in a uniform long-term capital gains tax across the canvas is indeed sensible. But questions have risen over the real intention. Is it simply a question of taxing the wealthy? Or, is it taxing the heavily taxed? Or, is it an attempt to level the field? The debate can go on till the cows come home.
The withdrawal of the benefit of indexation, nevertheless, is seen as a deliberate attempt to distort the asset allocation of investors. With the bankers’ lobby working overtime, it is a circuitous attempt to force investors in debt funds to channel their funds indirectly into banks. After all, mutual funds park funds in banks as well. By a single surgical action, an attempt is made to divert a considerable quantum of wholesale money into the banking system. What is incomprehensible is the manner in which this tax arbitrage possibility is sought to be erased and also the way it is pushed through, virtually without discussion in Parliament!
Significantly, there has been a demand for several years now for deepening the debt market to help fund the massive infrastructure needs of the country. Infrastructure projects are long-gestation and hence require long-term funding. Read in this context, it is hard to understand this move.
Its timing must be read in the context of mismatch in bank credit and deposit growth. Public sector banks increased their credit portfolio by 15.7% during the calendar year 2022, compared with 4.7% in 2021, the RBI said. Corresponding growth for private sector banks, however, remained higher at 19.1% (13.1% a year ago).
Aggregate deposits increased by 10.3% in December 2022 compared with 9.6% a year ago, led by 13.2% growth in term deposits. Current and savings deposits, however, recorded a moderate growth of 4.6% and 7.3%, respectively. Deposit mobilisation by public sector banks improved to 8.8% growth in December 2022 (6.9% a year ago) though it remained lower than 13.2% growth in deposits with private sector banks. “The increase in overall bank credit has also been influenced by the shift in borrowers’ funding choices from volatile bond markets, where yields have increased, and external commercial borrowings, where interest and hedging costs have increased, towards banks,” the Economic Survey said in January.
The banks have been feeling discriminated against. Bankers say that the benefit of indexation of long-term capital gains has put them in a disadvantageous position vis-a-vis mutual funds, which managed to snatch away cheap funds – public deposits – with the help of tax optimisation.
The tax benefit window shuts on March 31. Until then, the mutual fund industry has the option to drive as much money as possible into debt schemes, with tax benefits. Putting the pieces of the puzzle together, one can surmise that the tax sop is withdrawn to distort the asset allocation of investors. Former RBI governor D. Subbarao often said that inflation could hurt the poor the most. If that is so, why can’t term depositors be allowed the benefit of indexation? That could perhaps solve a host of problems and level the field. A surgical strike of this kind will only make the playing turf further uneven.
K.T. Jagannathan is a financial journalist.