Budget 2025: Will FM Nirmala Sitharaman Simplify Taxation on Mutual Funds to Encourage Investment?

As Finance Minister Nirmala Sitharaman prepares to present the Union Budget for 2025 on February 1, investors, financial planners, and market participants are all eagerly awaiting announcements that could potentially reshape the taxation landscape for mutual fund investments. After the Budget 2024 reforms introduced changes to the taxation of both short-term and long-term capital gains, the 2025 budget is expected to build on these changes, with the goal of making the tax structure more transparent, equitable, and investor-friendly.

One of the most anticipated changes relates to the taxation of mutual funds—both equity and debt. Investors have long struggled with the complexities surrounding capital gains taxes on these investments, with differences in tax rates based on holding periods, asset classes, and the nature of the mutual fund. The Budget 2025 may be the opportunity to streamline this system and encourage more retail investment, especially in a time when mutual funds are seen as an essential part of individual wealth creation.

To understand what investors can expect from Budget 2025, it is crucial to first take a close look at the key changes that were introduced in the previous year’s budget and how these might evolve in the upcoming one. This article examines the nuances of the current tax structure, the challenges faced by retail investors, and the potential reforms that may be announced to simplify taxation on mutual funds and foster greater participation in the market.

The Taxation of Mutual Funds: A Snapshot of the Current Scenario

The taxation of mutual funds depends primarily on the type of fund—equity or debt—and the duration of holding. In India, the Income Tax Act, 1961, defines the tax treatment of mutual funds, and recent budget changes have introduced a few important tweaks to this structure. Here’s a breakdown of the current taxation framework for equity and debt mutual funds:

1. Taxation of Equity Mutual Funds

Equity mutual funds are those that invest a minimum of 65% of their assets in domestic equity stocks. These funds are generally more popular among investors due to their potential for high returns over the long term. However, the tax treatment has evolved significantly over the years, especially since the introduction of capital gains taxes on equity mutual funds.

• Short-Term Capital Gains (STCG): If equity mutual fund units are sold within 12 months of investment, the capital gains are classified as short-term. The rate of tax on STCG has seen a substantial increase in the past few years. Following Budget 2024, the tax rate for STCG on equity mutual funds rose from 15% to 20%. This change took effect from July 23, 2024, following which any transfer of units within 12 months attracted a 20% tax.
• Long-Term Capital Gains (LTCG): When the equity mutual fund units are held for more than 12 months, the resulting gains are classified as long-term capital gains. While the LTCG tax rate had previously been 10%, Budget 2024 raised it to 12.5% for gains exceeding Rs 1.25 lakh in a financial year.

The rationale behind this increase was partly to balance the tax structure between short-term and long-term investing strategies. Small investors benefited from a tax-free limit of Rs 1.25 lakh for LTCG, encouraging them to hold onto their investments for the long term. However, some investors and experts argue that the increase in STCG and LTCG taxes could act as a deterrent to entry-level and retail investors who are otherwise looking for a tax-efficient way to invest in the stock market.

2. Taxation of Debt Mutual Funds

Debt mutual funds, on the other hand, invest primarily in fixed-income instruments such as bonds, government securities, and money market instruments. They are typically considered safer investments compared to equity funds, and hence, attract conservative investors.

Before April 2023, debt mutual funds were taxed based on the holding period, with a differential treatment for short-term and long-term gains:

• Short-Term Capital Gains (STCG): If debt fund units were sold within 36 months, the gains were treated as short-term capital gains and taxed according to the investor’s income tax slab.
• Long-Term Capital Gains (LTCG): If the units were held for more than 36 months, the gains were subject to a 20% tax rate with indexation benefits, where the capital gains were adjusted for inflation, thus reducing the taxable gain.

However, from April 1, 2023, the taxation of debt mutual funds underwent a significant change. All gains from debt mutual funds, regardless of the holding period, are now taxed at the investor’s applicable income tax slab rate. This change has led to higher tax liabilities for investors, especially those in the higher tax brackets.

3. Specified Mutual Funds

Budget 2024 introduced a distinction between specified and non-specified mutual funds, with the primary criteria being the proportion of assets invested in debt and money market instruments.

• Specified Mutual Funds: Funds that invest more than 65% of their assets in debt and money market instruments now fall under the specified category. These funds are subject to taxation at the investor’s applicable income tax slab rate, regardless of the holding period.
• Non-Specified Mutual Funds: Funds that invest less than 65% in debt are considered non-specified and are eligible for long-term capital gains tax treatment. For these funds, a 12.5% LTCG tax applies after a holding period of 24 months.

Additionally, gold ETFs, international equity funds, and silver funds now have different tax treatments. Gold ETFs, for instance, attract a LTCG tax of 12.5% after holding for 12 months, whereas gold funds have a holding period of 24 months for the same tax treatment.

The Case for Simplifying the Tax Structure in Budget 2025

While the tax changes in recent budgets were made with the intention of creating a more balanced tax framework, they have added to the complexity of the taxation system, especially for retail investors. The intricacies involved in understanding the holding periods, categorization of funds, and the varying tax treatments across asset classes have resulted in confusion for many investors.

The Government of India, through its various budget announcements, has often emphasized the importance of promoting retail participation in the capital markets. However, the inconsistent tax treatment across different asset classes has created barriers for small investors who are unable to navigate the complex tax regulations. There is a growing consensus among financial experts and market participants that simplifying the tax structure could foster a more inclusive investment environment.

Some of the key areas where simplification could take place include:

1. Uniform Tax Rates Across Asset Classes: Investors have long called for a uniform tax treatment for similar asset classes. For example, international equity funds are taxed differently from domestic equity funds, despite the fact that both are equity-based investments. Similarly, debt funds and gold funds are taxed differently, even though both are relatively conservative investment avenues. A uniform tax structure would make it easier for retail investors to compare funds and make informed decisions based on returns rather than tax implications.
2. Clarity on Holding Periods: One of the biggest sources of confusion among investors is the different holding period requirements for various types of mutual funds. Debt funds require a 36-month holding period to qualify for long-term capital gains tax treatment, while equity funds require just 12 months. Additionally, gold funds and ETFs have different holding period rules. By standardizing holding periods, the government could significantly reduce investor confusion.
3. Simplifying the Taxation of Debt Mutual Funds: The shift in tax treatment of debt mutual funds from a holding period-based structure to slab rate taxation has resulted in confusion and higher tax liabilities for many investors. A simpler system, perhaps with an adjusted tax rate that accounts for inflation (indexation), would encourage more investment in this category.
4. Encouraging Tax-Efficient Investment Strategies: With rising tax rates on short-term gains, retail investors are now more inclined to adopt long-term investment strategies. However, making the tax treatment more favorable for long-term investors across all asset classes could further promote this behavior. A potential reduction in LTCG taxes could serve as an incentive for retail investors to stay invested in mutual funds for the long haul.

What to Expect in Budget 2025?

Based on the feedback from industry experts and market participants, the following changes could be expected in Budget 2025:

• Standardization of Holding Periods and Tax Rates: The government might propose a uniform tax rate for equity, gold, and debt funds, with the same long-term capital gains treatment across all asset classes. This would make tax calculations more straightforward for investors and encourage more participation across various mutual fund categories.
• Reduction in LTCG Tax Rates: Given the recent tax hikes, there could be a potential reduction in long-term capital gains taxes for equity and debt mutual funds. This would align with the government’s push to promote long-term investing as a key driver of economic growth.
• Tax Incentives for Small Investors: The government could look to raise the tax-free limit on long-term capital gains for small investors, perhaps to Rs 2 lakh or beyond. This would allow more retail investors to benefit from tax-free profits, especially in the context of rising inflation.
• Revisions to the Tax Treatment of Debt Mutual Funds: To address concerns over the slab rate taxation of debt mutual funds, the government may consider a revision of tax rates or a return to the earlier indexation-based framework, which would provide more tax efficiency for long-term debt fund investors.
• Clarification on International Funds: The government may move to bring international equity funds under the same tax treatment as domestic equity funds. This would remove the complexity and attract more investments in global markets, which are increasingly important in the context of portfolio diversification.

Conclusion

The upcoming Union Budget for 2025 holds significant promise for the future of mutual fund investments in India. With the current tax structure being viewed as complicated and investor-unfriendly by many, there is a clear expectation that Finance Minister Nirmala Sitharaman will introduce measures to simplify the taxation system. By streamlining tax rates, aligning treatment across different asset classes, and providing more clarity on holding periods, the government has the opportunity to encourage greater retail participation in mutual funds, thereby fostering a more robust and inclusive investment ecosystem.

As the budget approaches, all eyes will be on the Finance Minister’s announcements and how they could impact India’s growing mutual fund industry, which remains one of the key pillars of retail wealth creation in the country.