Finance Act 2023: Capital Gains On Debt Funds, Why NRIs Must Redraw Retirement Projections

Non-resident Indians (NRIs) have had to redraw their retirement portfolio following a change in 2024. Under the Income-tax Act, 1961, prior to the Finance Act, 2023, gains arising from the sale of debt mutual funds were classified as long-term capital gains (LTCG) provided they were held for more than 36 months.

However, following the introduction of the Finance Act, 2023, the definition for specified mutual fund was amended. Under the new framework, gains arising from sale of a mutual fund (such as a debt mutual fund) which invests more than 65 per cent or more of its total proceeds in debt and money market instruments, will be treated as short-term capital gains (STCG), irrespective of the holding period and taxed at applicable slab rates for the investor.

Furthermore, following the Finance (No. 2) Act, 2024, the Income-tax Act, 1961 stipulates that capital assets acquired on or after July 23, 2024, are not eligible for indexation benefit.

Says Kunal Savani, partner, Cyril Amarchand Mangaldas: “On availing the benefit of indexation, one could adjust the cost of the said fund against the inflation using the cost inflation index (CII). Such indexed cost was subsequently reduced from the sale consideration/price to compute the long-term capital gains, which was taxed at a rate of 20 per cent (plus applicable surcharge and cess.”

“Therefore, any gains arising from the sale of debt mutual funds would be taxed as short-term capital gains at a rate of 30 per cent (plus applicable surcharge and cess), thereby increasing the tax liability of an investor, including the non-resident Indians (NRIs). With this tax parity, the competitive edge of debt mutual funds has diminished, and investors will have to pay higher taxes,” says Savani.

“Now, any gains arising from the sale of debt mutual funds would be taxed as STCG at a rate of 30 per cent (plus applicable surcharge and cess), thereby increasing the tax liability of an investor, including the non-resident Indians (NRIs). With this tax parity, the competitive edge of debt mutual funds has diminished, and investors will have to pay higher taxes,” he adds.

What It Means 

For NRIs, this translates to a definite tax increase. The removal means that if an NRI invested Rs 10 lakh in a debt fund and earned Rs 2 lakh in gains over three years, they would previously pay tax on inflation-adjusted gains. Now, the entire Rs 2 lakh gain faces taxation at their marginal tax rate. This impact becomes particularly severe for long-term holdings, as indexation would help NRIs save quite a bit in the long term.

Traditional NRI retirement planning tactics, which mostly depended on debt mutual funds for stability and tax efficiency, are disrupted by the increased tax liability.  “In the past, debt funds provided both capital protection and tax-optimized growth, making them the perfect intermediary between aggressive equity investments and cautious fixed deposits,” says Aashwyn Singh, senior associate, SKV Law Offices.

As the after-tax returns from debt funds have significantly decreased after indexation advantages were eliminated, many NRIs find that their retirement corpus projections have changed.  For NRIs approaching retirement who accumulate sizeable debt fund holdings over decades in the hopes of profiting from indexation upon redemption, the move is especially severe.

The possibility of far larger tax outflows now confronts NRIs who had planned systematic withdrawal plans from loan funds after retirement, which may compel them to prolong their working years. 

What NRIs Can Do

Singh says there are many strategies that can help NRIs manage this increased tax burden.

“Tax loss harvesting is the most immediate opportunity, where people can strategically sell underperforming debt fund units to offset capital gains from profitable investments,” says Singh.

This technique allows investors to reduce their net taxable capital gains while maintaining their overall portfolio allocation through reinvestment in similar assets. Another way to manage is by carefully timing redemptions across financial years. NRIs can optimise their tax liability, thus ensuring they utilise the full exemption amount annually rather than exhausting it in a single year.

“Alternative investment structures are also gaining prominence. NRIs are increasingly shifting toward equity-linked savings schemes (ELSS) for tax benefits under Section 80C, despite their three-to-five year lock-in period,” says Singh.