Budget 2025: Will FM Nirmala Sitharaman simplify taxation on mutual funds to encourage investment?
Finance Minister Nirmala Sitharaman is expected to table the Union Budget 2025 on February 1, 2025. This year’s full Budget, presented in the month of July, introduced several changes to the tax rules for mutual fund investments impacting both short-term and long-term capital gains.
FM Sitharaman tweaked the tax rates following which investors experienced an increased tax rate on profits from selling mutual fund units within a year. Similarly, the tax on long-term capital gains for investments held over a year saw a slight increase.
On the flip side, small investors saw a benefit from the raised tax-free limit on long-term capital gains, which is now set at Rs 1.25 lakh.
Here’s how mutual fund investments are taxed
The taxation of mutual funds depends on the type of mutual fund (equity and debt) and the duration of the investment.
For Equity Mutual Funds: Under the Income Tax Act, 1961, Equity mutual funds are defined as mutual funds that invest a minimum of 65% of their assets in equity shares of domestic companies.
In Budget 2024, the long-term capital gains (LTCG) tax on equity funds has been raised from 10% to 12.5%, while the short-term capital gains (STCG) tax has increased from 15% to 20%.
Short-Term Capital Gains (STCG): Gains from selling equity mutual fund units held for less than 12 months are considered Short-Term Capital Gains (STCG). These gains are taxed at 20% for transfers on or after July 23, 2024, and at 15% for transfers before that date.
Long-Term Capital Gains (LTCG): Gains from selling equity mutual fund units held for over 12 months are classified as Long-Term Capital Gains (LTCG). A 10% tax applies to gains exceeding Rs 1,25,000 in a financial year realized before July 23, 2024, and a 12.5% tax applies to gains realised on or after this date.
To ensure compliance with the Rs 1.25 lakh exemption for LTCG, investors should plan their investments strategically, promoting higher investments by smaller investors for tax-free profits. The rise in STCG tax for listed shares from 15% to 20% is expected to prompt investors to consider long-term trading strategies for their portfolios.
Tax on Debt Mutual Funds
According to the Income Tax Act, 1961, debt mutual funds are those that allocate less than 65% of their assets to equity shares.
Taxation of debt mutual funds before 1 April 2023:
Previously, the taxation of debt mutual funds was determined by the holding period rule:
Short-Term Capital Gains: If the debt mutual fund units were sold within 36 months (three years) of purchase, the gains were classified as short-term capital gains (STCG) and taxed at slab rates.
Long-Term Capital Gain: On the other hand, if the units were sold after 36 months, the gains were considered long-term capital gains (LTCG) and taxed at 20% with an indexation benefit, where gains were adjusted for inflation.
Beginning April 1, 2023, debt mutual funds are now taxed at the investor’s applicable slab rates regardless of the holding period. This change has resulted in increased tax liabilities for debt mutual fund investors.
Specified mutual funds
In the July budget presentation, the definition of specified mutual funds was amended to include funds with 65% or more exposure to debt and money market instruments. This adjustment means that only pure debt funds, a debt-oriented conservative hybrid fund, or a debt-oriented fund-of-fund with at least 65% in debt will be subject to slab rate taxation.
Gold funds and ETFs, as well as foreign equity funds and ETFs, will not fall into the specified mutual funds category. Gold ETFs, for example, will be taxed on Long-Term Capital Gains at a rate of 12.5% after holding for 12 months. However, these modifications will only take effect in the next fiscal year (FY26).
Under the revised guidelines, gold funds will now be eligible for Long-Term Capital Gains tax treatment after holding for 24 months, while gold ETFs will qualify after 12 months. The same rule will be applicable for international and silver fund of funds versus ETFs.
Hence, mutual funds that have more than 65% of their portfolio invested in debt instruments will be categorized as specified mutual funds per Section 50AA and subject to taxation at slab rate.
Conversely, funds with less than 65% invested in debt will receive Long Term Capital Gains (LTCG) tax treatment and be taxed at a rate of 12.5% after holding for 24 months. Additionally, equity-oriented funds holding more than 65% in equities will be subject to a 12.5% tax rate after holding for 12 months.
What’s expected from the Budget 2025
Investors have been anticipating FM Sitharaman to streamline the capital gains tax structure by aligning tax rates across various sub-asset classes. This may include, for instance, treating international equities the same as domestic equities, debt funds the same as gold funds, and gold funds the same as gold ETFs.
“The government wants to simplify the tax structure and, hence, has made capital gains tax uniform across various asset classes. Unfortunately, due to legacy issues, a lot of complexity still exists in the form of purchase dates of debt funds, international funds and even gold funds. These inconsistencies have created a lot of confusion in the minds of retail investors,” Vivek Banka, Co-Founder of GoalTeller told the Economic Times.