In this file photo, a general view of the Indian parliament building is pictured during the winter session in New Delhi on Nov 29, 2021. India will tax investments in debt mutual funds as short-term capital gains, according to amendments to the finance bill passed in parliament on March 24, 2023. (PHOTO / AFP)

NEW DELHI – India will tax investments in debt mutual funds as short-term capital gains, according to amendments to the finance bill passed in parliament on Friday, a move that could strip investors of the long-term tax benefits that made such investments popular.

The change could spur growth in bank deposits, which have been struggling to keep pace with the demand for credit over the past 12 months that led to a higher cost of funding for lenders.

The mutual fund industry is likely to request the finance ministry to take a relook at the decision, said two mutual fund executives on condition of anonymity

Mutual funds with less than 35 percent invested in domestic equities are proposed to be treated as short-term and the indexation benefits that help significantly reduce tax liability available to such funds may be removed prospectively, the amendments say.

As such, the tax rate applicable would be based on the income tax slab in which the investor falls.

Finance Ministry did not immediately respond to an email seeking comment.

"The impact would be meaningful, if you are a debt investor, you will compare returns with other debt instruments," said Radhika Gupta, managing director at Edelweiss Asset Management Company.

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The mutual fund industry is likely to request the finance ministry to take a relook at the decision, said two mutual fund executives on condition of anonymity.

As of Dec 31, 2022, assets under management for debt oriented products stood at 12.42 trillion rupees ($151.04 billion), according to industry data.

Currently, investors in debt funds pay income tax on capital gains according to the income tax slab for a holding period of three years. After three years these funds pay either 20 percent with indexation benefits or 10 percent without indexation.

The new tax rules would apply to investments made on or after April 1, 2023, impacting new inflows into these funds.

"Debt mutual funds had a favorable tax regime as compared to banks' fixed deposits and small savings," Amit Maheshwari, a tax partner at AKM Global said, adding now debt mutual funds will be taxed at par with other investments. "This could impact debt mutual funds investments in corporate bonds."

This move is targeted mostly towards high net-worth individuals who were using this investment as a tax-saving instrument, Maheshwari said.

Mutual funds provided liquidity to debt investors, and the move is counter-productive to efforts for deepening bond markets in India, said Edelweiss' Gupta.

Indian banks, holding 178 trillion rupees in deposits, may be the beneficiaries if the proposed amendment is approved.

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Money from high net-worth individuals and institutions is invested in these funds, which may get diverted to bank deposits, said Suresh Khatanhar, deputy managing director at IDBI Bank.

Mutual funds used this money to fund the working capital needs of corporates. "If they get lesser funds due to end of the arbitrage, it will also be a positive for banks, as this business opportunity will flow to banks for refinance," Khatanhar added.

Bank deposits grew 10.1 percent over a year ago in the fortnight ended Feb. 24, while credit demand rose 15.5 percent.