How debt investors can lower their higher tax liability by investing in hybrid funds?

In order to provide investors with a diverse portfolio, hybrid mutual funds are a form of investment vehicle which typically invests in a blend of stocks, bonds, and other assets. Securities like mutual funds that have debt or equity proportions exceeding 35% but below 65% are considered hybrid securities. Following the budget 2023, hybrid instruments held for longer than a year are now more tax advantageous than debt funds because they are subject to a 20% tax rate and may even be eligible for an indexation benefit. Contrarily, the sale of debt mutual funds is subject to a slab rate of taxation that can reach 30%. Hence, here’s how can you lower your higher tax liability by investing in hybrid funds based on a discussion with multiple industry experts.

Aamar Deo Singh, Head Advisory, Angel One

Investors are exploring investment options, with taxation benefits post the government’s withdrawal of tax benefits in the debt funds. Hybrid fund by definition, invest in more than one asset class, and its mostly a combination of debt and equity. And the best part is, hybrid funds are treated as equity funds, so if held for less than a year, an investor pays STCG tax of 15% while for holding period exceeding one year, LTCG taxation rate of 10% is applicable. So, those investors who were earlier deriving taxation benefits by investing in debt funds, are now looking at hybrid funds. But one needs to understand, that these funds have a component of equity, which makes them more vulnerable to market moves, as compared to debt funds.

Dhaval Selwadia, Partner, Direct Tax, N.A. Shah Associates

Long Term capital arising from Equity oriented funds is taxable @10% plus applicable surcharge and cess (on gain exceeding Rs. 1,00,000) u/s 112A and Short-Term capital arising from Equity oriented funds is taxable @15% (plus applicable surcharge and cess)

Until now, long Term capital gain on debt-oriented fund is taxable @20% (plus applicable surcharge and cess) with indexation benefit. However, Finance Act 2023 has made amendment, as per which investment in debt fund (having investment in more than 35% in debt fund) made on or after 01.04.2023 will be treated as short term capital gain and taxable as per applicable slab rate.

Hybrid Funds are mutual fund schemes which invest in more than one asset class i.e. equity, debt and other asset classes depending on the investment objective of the scheme.

With the changes in Budget 2023, investment in hybrid funds has emerged as a suitable option for investor. Though it may involve taking some additional risk, an investor can think about hybrid funds, with a gross exposure of over 65% in equities and balance in debt so that it can qualify as equity-oriented fund which is at lower rate.

Suresh Surana, Founder, RSM India

The Finance Act 2023 by way of introduction of Section 50AA of the Income Tax Act, 1961 (hereinafter referred to as ‘the IT Act’) provided that any gain or income arising on transfer, redemption or maturity of units of specified mutual funds (wherein not more than 35% of the total proceeds are invested in equity shares of domestic companies for instance, certain debt funds) acquired on or after 1 April 2023 will be deemed as short term capital gains, and subject to tax at the applicable slab rate of the investor, irrespective of the period of holding. Since such gains would be deemed to be short term in nature, no indexation benefit would be available in case of such short term capital gains.

Prior to the amendment made by the Finance Act 2023, such debt fund units when held for more than 36 months would be subject to tax @ 20% u/s 112 of the IT Act after availing the indexation benefit.In order to avoid the higher tax rate, many investors may optimise their tax planning by way of investing in a combination of hybrid instruments which may not fall within the criteria of specified mutual funds (where more than 35% but upto 65% of its total proceeds is in equity shares) and accordingly, the tax rate in such case would be a flat 20% and further, they may be able to avail the indexation benefit.

Further, taxpayer may also consider investing in equity-based hybrid funds (a mutual fund which invests more than 65% of its proceeds in the equity shares of domestic companies) as the long term gains from such funds would be subject to tax @ 10% u/s 112A of the IT Act on gains exceeding Rs. 1,00,000, provided the period of holding for such investment is more than 12 months whereas the short term gains would be taxed at 15% u/s 111A of the IT Act subject to payment of STT on the same.

Thus, investors/ taxpayers (in case their effective tax liability u/s 50AA is higher as compared to their tax liability u/s 112A/ 111A/ 112) may consider the aforementioned illustrative options for investing in hybrid funds for efficient tax optimization.

Archit Gupta, Founder and CEO, Clear

Hybrid funds are normally taxed similarly to Equity Mutual Funds, i.e. in case they are held for a period in excess of 12 months, the gains arising form transfer of it are taxed at 10%, that too after giving a deduction of ₹1 Lakhs form the gains.

For example if the long term gains are ₹2,50,000 then tha taxable LTCG will be ₹1,50,000 and it would attract a tax rate of 10%, and the tax liability would come to be ₹15,000. This will be increased by Health and Education cess and Surcharge (if any).

If they are held for a period not exceeding 12 months then also a special rate of 15% is applied on the gains amount.

Juzer Gabajiwala- Director, Ventura Securities

Prior to 1 April, 2023,, any fund other than an equity oriented mutual fund had a taxation structure which allowed the benefit of indexation, if any investment wss held for more than 3 years and post indexation the taxation was levied at 20% plus cess and surcharge, if any. However, post 1 April, 2023 the entire taxation structure for these funds have been changed for all investments made post 1 April, 2023. Post the latest Amendments (applicable from 1st April, 2023) to Finance Bill 2023, below taxation is applicable depending on the equity exposure (%) a scheme maintains:

Investors can look at Hybrid funds as an option where in the equity exposure is between 35-65% in order to have the same taxation structure as before for a debt fund. However, one should bear in mind that the investor will need to keep the asset allocation structure which he is comfortable when he is opting for a hybrid model of investing. So for eg in an investor was previously investing say 50% in equity and 50% in a debt fund independently, he can now look at a Hybrid fund with a similar exposure to reduce his tax component.

Lakshmikumaran & Sridharan Attorneys

Hybrid funds making equity investments in the range of 35% to 65% may be used by investors to mitigate their risk as well as tax cost. If the investment in these funds are held for more than 3 years, then capital gains from these units will be taxable at a concessional rate of 20%. Moreover, the indexation benefit will also be allowed in such cases.

In India, traditionally, risk averse investors have resorted to investment in traditional instruments like time deposits, debentures and bonds. However, investments in such debt instruments is not tax effective as the interest may be subject to tax on accrual basis as per the applicable slab/corporate tax rates. Further, owing to the reduction in interest rates in recent years, many of these instruments may not offer competitive returns. Therefore, investors resort to investment in hybrid mutual funds to manage their risk and tax cost.

Mutual funds allow the investors two-fold benefit. Firstly, many funds were structured to re-invest their receipts (rather than distributing it to unit holder), allowing the unit holder to accumulate income (as increase in NAV) without payment of tax. Secondly, the income from transfer of the units from the funds may be taxable at concessional rates as compared to interest income.

Pursuant to amendment made vide Finance Act, 2023, capital gains from “Specified Mutual Fund” is taxable as short-term capital gains only. Specified Mutual Funds have been identified as funds wherein equity investment is not more than 35%. These funds may though allow the unit holders to defer the taxation upto the date of transfer may not allow any tax concessions.

Mutual funds investing more than 35% but less than 65% in equity may allow the best of both worlds to the investors. On one hand, owing to a relatively lesser equity investment, a major part of the investments may assure a fixed return. At the same time, if these units are held for a period exceeding 36 months, the capital gains from these units may be taxable at a concessional rate of 20%. Further, the indexation benefit allowed in such cases may further reduce the tax cost.

To encourage equity participation, “Equity Oriented Mutual Funds” (wherein at least 65% of the funds are invested in the equity shares of listed companies) offer concessional tax rates of 10% (in case where units are held for more than 12 months) and 15% (in other cases). However, such funds add to the overall risk appetite of the investors. Nevertheless, equity-oriented fund containing healthy debt investment (say between 30 to 35%) can optimise the risk as compared to traditional investment in listed shares of a company.

Hybrid instruments offer varied benefits as compared to traditional mode of investment. These funds can be used by the investors to manage their risk and tax cost. While, higher equity participation offers reduced tax cost, the investors will have to bundle their decision making with their risk appetite.

Mohit Ralhan, Chief Executive Officer TIW Capital

For investors maintaining a portfolio mix of equity and debt mutual funds where equity mutual funds account for more than 65% of the portfolio, investing in hybrid funds makes good sense, given the preferential tax treatment. The gains on pure debt funds are taxed at the investor’s income slab rate. On the other hand, hybrid funds which have a gross exposure of over 65% to equities (equity savings, aggressive hybrid funds and arbitrage funds) are taxed as equity-oriented funds, where STCG is 15% while LTCG on capital gains exceeding INR 1 lac is 10%. Therefore, investors can maintain the desired portfolio mix between equity and debt but create a more tax-efficient portfolio by investing in appropriate hybrid funds.

Aditya Damani, Founder & CEO, Credit Fair

With hybrid funds, investors can invest in equity, debt and commodity. However, investors can reduce tax liability by increasing gross exposure to equity, as equity savings hybrid funds are taxed as equity-oriented funds. However, one needs to evaluate her/his risk appetite before making such investments, as investing in equity comes with a certain level of risk.

Vivek Jalan, Partner, Tax Connect Advisory, a multi-disciplinary tax consultancy firm

Hybrid instruments are those instruments, like mutual funds, which have debt or equity above 35% each but not higher than 65% each.

After the budget 2023, hybrid instruments held for a period of more than 1 year have become more tax beneficial in comparison to debt funds (where debt proportion is higher than 65%), as they are taxable at 20% and even indexation benefit is available. In contrast, the sale of debt mutual funds is taxed at a slab rate which may go up to 30%.

Although equity mutual funds tax is lower than hybrid funds, yet their risks are substantially higher, which tilts the favour in balance of hybrid funds.

Ashish Misra, chief operating officer - retail banking at Fincare SFB

Investing in hybrid funds can be a smart way to reduce your tax liability, as these offer a combination of equity and debt investments that provide tax benefit. Hybrid funds are classified based on the proportion of equity and debt instruments they invest in, with aggressive hybrid funds allocating a higher percentage to equities and conservative hybrid funds investing more in debt instruments. By investing in hybrid funds, you can take advantage of the lower tax rate on long-term capital gains from debt investments and the tax-saving benefits of equity investments. 

Moreover, some hybrid funds qualify for tax-saving benefits under Section 80C of the Income Tax Act as they invest up to 65% of their corpus in equity. If the investment is held for more than three years, long-term capital gains tax is levied at a lower rate of 20% with indexation, further reducing the tax liability. However, it's important to note that investors must conduct thorough research before investing and consider various factors including, fund performance, expense ratio, and risk profile, among others.

Rahul Jain, President & Head, Nuvama Wealth

Hybrid funds that invest more than 65% of their assets in domestic equities are taxed as equities. This means that short-term gains are taxed at 15%, while long-term gains are taxed at 10%. Investors who keep separate portfolios of equity and debt funds can replace some of the equity and debt funds with the hybrid funds mentioned above. Because debt funds are now taxed at the maximum marginal rate, this can reduce the overall tax liability.

Atul Sharma, Founder, Lex N Tax

Investing in hybrid funds can potentially help lower your tax liability, but it is important to understand how hybrid funds work and how they can impact your taxes.

Hybrid funds are mutual funds that invest in a mix of equity and debt securities. They can be classified into three categories based on their asset allocation: conservative, balanced, and aggressive. Conservative funds typically have a higher allocation towards debt securities, while aggressive funds have a higher allocation towards equity securities.

When you invest in a hybrid fund, you are indirectly investing in both equity and debt securities. The returns generated by these funds are a combination of dividend from equity and interest income from debt. In India, equity-oriented hybrid funds have a tax advantage over pure debt funds, as they qualify for long-term capital gains tax of 10% without indexation on gains above Rs. 1 lakh if held for more than one year. However, pure debt funds are taxed at a higher rate, based on the individual's tax bracket. Amendment to finance bill 2023 has scrapped the benefit of indexation on debt mutual fund. Earlier it was taxed at the rate of 20% with indexation benefit if held for more than three years.

In India, dividend income from mutual funds is subject to a dividend distribution tax (DDT). However, equity-oriented hybrid funds (where at least 65% of the fund's assets are invested in equities) are exempt from DDT. So, if you invest in such a hybrid fund and earn dividends, you will not have to pay any DDT, which can result in lower tax liability. It is also important to note that if hybrid fund is Hybrid Equity oriented funds (Investment in Equity is≥ 65%) held for less than 1 year then it will attract short term capital gain u/s 111A at 15%.

Investing in hybrid funds, especially equity-oriented ones, can potentially help reduce your tax liability by generating long-term capital gains, which are taxed at a lower rate than short-term capital gains or interest income. However, it is important to note that hybrid funds are subject to market risks (due to its equity element) and can potentially result in losses.

Additionally, it is crucial to consult a financial advisor or tax professional and do proper research on past track record of fund before investing in any financial instrument to ensure it aligns with your overall financial goals and is suitable for your individual tax situation.

Babita Rani, Tax Consultant

Investment in hybrid funds has become a viable choice, particularly in light of the Finance Bill, 2023 modifications that have only lately been introduced. Capital gains from debt-oriented mutual fund schemes will be regarded as short-term capital gains starting on April 1, 2023, regardless of the holding duration.

An investor might consider adding hybrid funds having a gross exposure of over 65% to stocks to their investing portfolio to acquire incremental exposure to debt, even if it may require taking on some additional risk. As they will be treated as equity-oriented funds, an investor will benefit from tax efficiency in this way. An investor can divide their assets among the three asset classes of stock, debt, and commodities by investing in hybrid funds.

Investments in several asset classes can help reduce the volatility (a measure of risk) of the total portfolio during periods of jarring changes in a single asset class since these asset classes have a low or negative correlation between one another. The main benefit of choosing hybrid funds is the lack of linearity between the asset classes.

Himani Chaudhary, finance creator

Investing in Hybrid Mutual Funds can help lower your higher tax liability, but it's important to consider other factors as well.

According to recent changes in tax regulations, investors have to pay tax on debt funds according to their income tax slab. So, investing in balanced mutual funds, which have both equity and debt exposure, is a better option. Hybrid mutual funds can be a good alternative to investing separately in an equity and a debt mutual fund, but they may have more equity exposure than debt. Nonetheless they still enjoy a lesser tax of 10% long term capital gains tax after 1 year.

But it also incurs higher risk in the portfolio. Investors should be prepared for significant losses when the market is down.

Ideally, taxation should not be the sole reason for investing in hybrid mutual funds. One should only consider their investment goal, risk appetite and investing period.

Frequent changes in investments due to changes in taxation may result in fees and penalties that can outweigh any potential benefits.

Jagriti Arora, Assistant Professor, Finance, Great Lakes Institute of Management

In a hybrid fund, the tax is levied only on capital gains realised. So, the benefit is that as long as one is not realising any gain, there is no tax liability.

Although the indexation benefits have been taken away starting this financial year, one can still defer the tax liability to subsequent years which will also lead to better compounding of the investments.

Anant Jain, Partner, Legacy Growth

The high net worth individual can prefer to invest in Equity Oriented Hybrid Mutual Funds vis-a-vis pure debt funds or fixed deposits.

The tax rate for hybrid funds would be 15% if sold within one year and 10% if these are sold after one year vis-a-vis debt funds / FD which may be taxed at a higher rate of 39% to 43%.

The hybrid funds are more volatile than pure debt funds / FD due to market fluctuation on account of higher allocation to equity.