Since the introduction of the Finance Bill 2023, the taxation of debt mutual funds has changed; and this change has led investors with higher tax liabilities to turn to hybrid mutual funds as an alternative. However, are the two categories of investment one and the same? Is the risk posed by a hybrid mutual fund investment the same as the one posed by a debt mutual fund investment? To understand these details, the investor must learn more about hybrid mutual funds and the details of their taxation.
What are hybrid mutual funds, and what are their features?
Investments are generally divided into three major categories – equity investments that pose the highest risk to the investor, debt investments, and hybrid investments. Hybrid mutual funds are a combination of equity and debt mutual fund schemes that are designed to meet the investment objective of the scheme. The fund manager of a hybrid mutual fund determines the fund’s objective, and then allocates funds in equity and debt instruments in specific proportions. Here are the key features of hybrid mutual funds:
- Hybrid mutual funds carry an investment risk that is proportionate to the allocation of assets in the portfolio.
- Investors can invest in five major categories of hybrid funds – Equity-oriented hybrid funds, Debt-oriented hybrid funds, Balanced Funds, Monthly Income Plans, and Arbitrage Funds.
- The taxation of hybrid funds varies for the equity component and the debt component. The Equity component is taxed like equity mutual funds – Long-Term Capital Gains (LTCG) of more than ₹ 1 lakh are taxed at 10% without indexation; and Short-Term Capital Gains (STCG) are taxed at 15%. The debt component is taxed like any other debt mutual fund, as per the applicable income tax slab of the investor. LTCG from the debt component are taxed at 20% after indexation and 10% without indexation benefits.
How can debt investors lower their tax liability by investing in hybrid funds?
Before the rule change brought about by the Finance Bill 2023, debt fund investors could avail an indexation benefit if they held on to their debt fund units for more than 36 months and were subject to tax at 20% under Section 112 of the Income Tax Act. However, after the Finance Bill 2023, all capital gains on debt mutual funds will be treated as short-term capital gains and taxed as per the investor’s tax slab. Debt investors can lower their tax liability by investing in a combination of hybrid instruments which may not fall within the criteria of specified mutual funds (where more than 35% but up to 65% of its total proceeds are equity shares). Furthermore, the tax rate in this case would be flat 20% and the investor will also be able to avail an indexation benefit.
Investors who have a higher tax liability can therefore invest in hybrid mutual funds instead of debt mutual funds to lower their overall tax liability. Investors should use a mutual fund calculator before making any hybrid fund investment.
