There was a hue and cry after the Union Budget 2024-25 as the Centre increased the long-term capital gains (LTCG) tax on equity from 10% to 12.5%. However, since April 2023, the benefit of indexation has been taken away from debt-oriented mutual funds (MFs), and it is taxable at marginal slab rate (MSR). For most investors, the MSR is 30%.
This is a skew. The logic behind a relatively lower LTCG rate for equity than the MSR for majority investors is that the nation requires capital for growth. Incentivizing people to invest in equity would lead to a source of capital for the corporate sector. However, corporations raise capital through the issuance of bonds as well. In terms of importance in the overall picture, bonds as a source of capital are not a poor, distant cousin of equity.
The outstanding quantum of corporate bonds is ₹50 trillion, which shows their importance. There is no exact corresponding number for resources raised through equities, but there is a ballpark estimate. India’s market capitalization (National Stock Exchange of India, 22 January 2025) is ₹421 trillion/$4.87 trillion.
However, this is not the quantum of capital raised by corporations. The resources that have flowed to corporations are the face value of the shares or face value plus premium if the primary issue was at a premium. Market capitalization is the product of outstanding stock and market price. As we all know, the market price is multiple times the face value.
In other words, the corporate sector has availed of a fraction of ₹421 trillion through the issuance of shares. The ballpark estimate for discussion purposes is 20%, which is around ₹84 trillion.
In a sense, the tax structure is a “message” from the government. Equity becomes long-term for taxation purposes after one year of holding.
LTCG vs STCG
As any equity expert will tell you, which is corroborated by data as well, that equity is a long-term game to tide over market cycles and take home decent returns. Here, long-term means 10 years, not one year. For debt MFs, it is taxable as short-term capital gains, irrespective of the holding period. The implication is that even if you hold for 10 years, it will not become long-term for taxation purposes.
Short-term capital gains (STCG) are taxable at your MSR, whereas equity (less than one year of holding) has a flat rate of 20%. Ideally, given that debt funds are less volatile than equity, it should have been a lesser holding period for LTCG eligibility, but it is topsy-turvy.
We have spoken about debt MFs so far, whereas directly investing in bonds is possible. In equities, the taxation rate is the same for direct stocks and MFs, which is an LTCG rate of 12.5% beyond ₹1.25 lakh per fiscal year. In direct bonds, the coupon (interest) is taxable at MSR. The LTCG, which is 12.5%, is applicable to listed bonds with a holding period of more than one year.
However, one thing has to be seen in perspective. In equity investments, you earn from price appreciation; the dividend yield is approximately 1% on average. In bonds, you earn mostly from the coupon (interest). Capital gains are realized when you sell the bond at a profit prior to maturity. Most bond investors hold till maturity, hence paying tax at MSR on the coupon.
MFs vs bank deposit
There is a perception that MFs compete with bank deposits. However, this also has to be seen in perspective. If we go by sheer numbers, then MF assets under management (AUM) of ₹68 trillion as on the end of December 2024 is 31% of bank deposits of ₹220 trillion on the same date.
As discussed in the Mint article published on 30 September 2024, bank deposits and MFs are cogs of the same wheel. Bank deposits are counted at face value. In MFs, NAV is calculated every day at market prices. NAV goes up, along with the growth of the price of the underlying stocks. When the market is in a bull phase, MF AUM grows at a commensurate pace. While there is no exact data to bifurcate MF AUM growth between fresh investments and mark-to-market (MTM) related uptick, we can form a perspective. The ballpark estimate is, in equity funds, approximately one-fourth, or at least less than one-third, is fresh cash. The rest is market price appreciation over the last few years. In debt funds, AUM is approximately ₹20 trillion, which is 9% of bank deposits.
Net-net, there is a case for revising LTCG taxation for debt funds with a one-year holding period.
Joydeep Sen is a corporate trainer (financial markets) and author.