Budget 2025: Will FM Nirmala Sitharaman simplify taxation of mutual funds to encourage investments?

Finance Minister Nirmala Sitharaman is expected to present the Union Budget 2025 on February 1, 2025. This year’s general budget, presented in July, introduced several changes to the tax rules for mutual fund investments, impacting both short-term and long-term capital gains.

FM Sitharaman optimized tax rates following which investors experienced increased tax rate on gains from sale of mutual fund shares within a year. The tax on long-term capital gains for investments held for more than one year was also increased slightly.

On the other hand, retail investors benefited from the increased tax exemption limit on long-term capital gains, which now stands at Rs 1.25 lakh.

This is how investments in mutual funds are taxed

The taxation of mutual funds depends on the type of mutual fund (stocks and debt) and the length of time the investment is held.

For Equity Mutual Funds: According to the Income Tax Act, 1961, Equity Mutual Funds are defined as mutual funds which invest at least 65% of their assets in shares of domestic companies.

In Budget 2024, the long-term capital gains tax (LTCG) on equity funds has been increased from 10% to 12.5%, while the short-term capital gains tax (STCG) has been increased from 15% to 20%.

Short-Term Capital Gains (STCG): Gains from sale of equity fund shares held for less than 12 months are considered Short-Term Capital Gains (STCG). These gains will be taxed at 20% for transfers made on or after July 23, 2024 and at 15% for transfers before that date.

Long-Term Capital Gains (LTCG): Gains from sale of equity fund shares held for more than 12 months are classified as Long-Term Capital Gains (LTCG). Gains of more than Rs 1,25,000 in a financial year realized before July 23, 2024 will be subject to tax of 10% and gains realized on or after this date will be subject to tax of 12.5% %.

To ensure compliance with the Rs 1.25 lakh exemption for LTCG, investors should strategize their investments and encourage higher investments by smaller investors for tax-free gains. The increase in STCG tax on listed stocks from 15% to 20% is likely to prompt investors to think about long-term trading strategies for their portfolios.

Tax on debt mutual funds

According to the Income Tax Act, 1961, debt funds are those which invest less than 65% of their assets in equities.

Taxation of debt funds before April 1, 2023:

Previously, the taxation of investment funds was determined by the holding period rule:

Short-term capital gains: If the mutual fund shares were sold within 36 months (three years) of purchase, the gains were classified as short-term capital gains (STCG) and were taxed at flat rates.

Long-Term Capital Gain: On the other hand, if the shares were sold after 36 months, the gains were considered Long-Term Capital Gains (LTCG) and were taxed at 20% with an indexation benefit, with the gains adjusted for inflation.

Effective April 1, 2023, debt mutual funds will now be taxed at the flat rates applicable to the investor, regardless of the holding period. This change has resulted in increased tax liabilities for debt mutual fund investors.

Specified investment funds

In the July budget proposal, the definition of certain mutual funds was changed to include funds with 65% or more invested in 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 funds with at least 65% leverage will be subject to the flat tax.

Gold funds and ETFs as well as foreign equity funds and ETFs do not fall into the specified category of mutual funds. For example, gold ETFs are taxed at a 12.5% ​​tax rate on long-term capital gains after a 12-month holding period. However, these changes will only take effect in the next financial year (FY26).

As per the revised guidelines, gold funds will now be eligible for long-term capital gains tax treatment after being held for 24 months, while gold ETFs will be eligible after 12 months. The same rule applies to international and silver funds of funds compared to ETFs.

Therefore, mutual funds that have more than 65% of their portfolio invested in debt securities are categorized as certain mutual funds under Section 50AA and are subject to tax at the flat rate.

Conversely, funds that are less than 65% invested in debt receive long-term capital gains (LTCG) tax treatment and are taxed at a rate of 12.5% ​​after 24 months of holding. In addition, equity-oriented funds that hold more than 65% in stocks are subject to a tax rate of 12.5% ​​after a holding period of 12 months.

What is expected from the 2025 budget?

Investors have expected FM Sitharaman to rationalize the structure of capital gains tax by equalizing tax rates for different sub-asset classes. This may include, for example, treating international stocks equally with domestic stocks, treating debt funds equally with gold funds, and treating gold funds equally with gold ETFs.

“The government wants to simplify the tax structure and has therefore standardized the capital gains tax for various asset classes. Unfortunately, there is still a lot of complexity due to legacy issues in the form of purchase data of debt funds, international funds etc. Even gold funds have created a lot of confusion among retail investors,” Vivek Banka, co-founder of GoalTeller, told The Economic Times.