LTCG Impact, Sahi Hai?  

As a catchphrase, “Mutual Funds Sahi Hai” deserves much credit for the eightfold increase in total assets under management from ₹8.26 trillion in December 2013 to around ₹66.93 trillion in December 2024. But can the same be said for the taxation of financial assets like mutual funds—more specifically, can we say, “Capital gains tax sahi hai”? A look at the evolution of capital gains tax changes and their impact on the financialisation of savings.  

For starters, take equity mutual funds. From 1998 to 2018, equity mutual funds enjoyed an era of tax-exempt long-term capital gains, creating an opportunity to compound wealth for over 220 million Indians who use mutual funds as an alternative to traditional avenues like bank deposits, small savings, corporate deposits, physical gold, and real estate. The initial provision exempted long-term capital gains on equity mutual funds for a holding period of 12 months.  

The earth moved for equity mutual funds in 2018 when the grandfathering provision was introduced, allowing long-term capital gains accrued until 31 January 2018 to remain tax-exempt. Any gains beyond that date and a specified limit would be taxed at 10%. This was increased to 12.5% in 2024 while raising the short-term capital gains rate from 15% to 20%. So far, so good for equities, which saw the unleashing of animal spirits for 20 years before the harvest of tax in two seasons in 2018 and 2024.  

The most significant disruption came in the post-election Budget on 23 July 2024, impacting debt mutual funds, which invest over 65% in debt securities, and specified mutual funds, which invest between 35% and 65% in equity instruments. In one fell swoop, the regime impacted long-term capital gains on them, making them less tax-efficient and unattractive.  

Here's why: The indexation benefit on long-term capital gains from debt mutual funds was removed, making the entire capital gain now taxable at slab rates with a large outgo. This, combined with inflation effects, has made debt mutual funds' real returns negative, impacting every investor. The changes had a retrospective effect, so investments made before 1 April 2023 were brought in, which were previously grandfathered. This impacted thousands of long-term investors who had earlier locked into high-yielding debt mutual funds for financial security.  

All these measures have dented debt mutual funds in ways that took the sheen off. They are now unattractive compared to bank deposits, and except for the overnight and liquid fund categories of mutual funds, flows to long-term debt mutual funds have taken a severe beating since this regime changed. While equity mutual funds grew 43.9% in the last 12 months, from ₹342 trillion to ₹49.2 trillion, debt mutual funds, excluding liquid and overnight funds, grew negligibly from ₹570 billion to ₹1.2 trillion. Clearly, the complexities of capital gains tax changes in debt mutual funds have failed to lure retail or high-net-worth investors into long-term funds, even when the 10-year government bond yield moved 53 basis points south from 7.28% to 6.75%.  

This new taxation regime has equated mutual funds and bonds with bank deposits despite fundamental differences:  

Risk and Insurance: Bank deposits are protected by deposit insurance, while mutual funds and bonds are not.  
Regulatory Backing: Deposits have an implicit backstop from the Reserve Bank of India. However, investors in debt mutual funds assume both interest rate risks and credit risks without any support from the Reserve Bank of India or the government.  
Infrastructure Funding Needs: India's infrastructure push requires long-term debt capital of 3-8 years, which cannot be met through bank deposits or one-year bonds. Debt mutual fund investors need sweeteners in the form of higher tax efficiency or a higher coupon that is reasonably grandfathered for long-term holding.  
Fair Compensation: Long-term capital gains benefits with indexation were a fair compensation earlier enjoyed by long-term debt mutual fund investors. This must be urgently restored and even extended to bank deposits of over five years.  
The government needs a healthy growth of the debt market for stakeholders like the Reserve Bank of India, insurance regulators, pension authorities, and mutual funds—financed by savers and investors with long-term risk appetite. The new tax structure could be designed to incentivise long-term investments by charging lower taxes for assets held over extended periods. This can promote stability and sustainable growth in the domestic bond market with domestic savers and investors.  

Remember the Asian currency crisis of 1997? Massive market borrowings in US dollars fuelled capital market growth, only leading to a meltdown later after capital flight by foreign investors. There is a present value of financial history in that backdrop. Last year, foreign institutional investors pulled ₹3,042.7 billion from the Indian stock market. Could this happen in the bond markets, too? Now, decide if “LTCG rates sahi hai” for debt mutual funds—or if they need tweaking to rewrite India’s financial history in the making.