The amendment to treat gains on debt mutual fund as short-term capital gains and removal of indexation benefit will substantially diminish the attractiveness of these products. International funds, gold funds and funds of funds (FoFs) will also be impacted as government made changes to Finance Bill 2023.

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As per the changes, gains from mutual funds where not more than 35 percent is invested in equity shares of Indian companies will now be deemed to be short-term capital gains w.e.f. April 1, 2023.

This comes at a time when mutual funds have already been seeing outflows from debt schemes. The only segment that saw inflows was the the spate of target maturity funds which were passively holding G-secs, mimicking fixed deposits but with tax benefits. In the month of February, debt mutual funds witnessed a big outflow with a figure of Rs 13,815 crore as investors churned their allocation between short- and long-term funds.

So far, the average asset under management (AUM) stands at Rs 7.9 lakh crore in FY23. In FY22 and FY21, this was at Rs 10.3 lakh crore and Rs 9.3 lakh crore, respectively.

The individual investor allocation, as of now, stands at 14 percent so far in FY23. In FY22 and FY21, it stood at 15 percent and 22 percent, respectively.

In terms of institutional investor allocation, debt funds stand at at 34 percent so far in the current financial year. It was at 34 percent and 32 percent in FY22 and FY21, respectively.

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What happens now?

Yeeshu Sehgal, Head of Tax Market at AKM Global, believes that debt funds will lose attractiveness as an investment option and the investors may resort to invest in alternate options such as fixed deposits, etc. The industry may also see a shift of money from long-term debt funds to equity-oriented funds due to taxation benefit.

The change will, however, not affect corporates or HNIs who invested in debt MFs for shorter periods (less than three years). All existing investments and new investments made before March 31, 2023 will also not be affected by this proposed tax change.

"The aforesaid proposal is subject to enactment after approval of both the houses of Parliament (at present Lok Sabha has passed the Bill) and assent of the president of India," said Saurav Basu, Head, Wealth Management at Tata Capital.

What should investors do?

Investors should use the window available till March 31, 2023 to invest into target maturity funds (TMFs) and long-term income funds.

"Though, TMFs are season's favourite and selling like hot cakes, allocation in other debt instruments in addition to them will help maximise returns and reduce volatility. TMF is suited for investors who want absolute returns within 3-4 years maturity. Here investors should have limited expectation from gains from rate reversal. While, in order to maximise the opportunity available due to the end of rate cycle, investors should tactically allocate to various debt funds, including TMFs and other long-term fixed income funds with modified duration of more than 6-7 years at least. The idea is to have a skew towards long-duration schemes, " said Girish Lathkar, Partner Private Wealth at Upwisery Capital Advisors LLP in a conversation with CNBC-TV18.com.

Sandeep Bagla, CEO at Trust Mutual Fund, believes that in spite of the tax benefit, investors may be reluctant to redeem even after completion of three years now as incremental income from these investments may remain tax efficient.

"Few investors may remain invested wanting to defer tax as tax is payable only at redemption. Incremental inflows will come into funds who are able to manage their portfolios actively and generate inflation beating returns for investors. There is likely to be no impact in the short term but could impact the ability of mutual funds to attract debt flows in the long term," Bagla said.

Impact on bond markets and corporates

Arihant Bardia, CIO and Founder Valtrust, said this is a retrograde step for the Indian bond markets.

"Mutual funds are major institutional player in the bond markets which lacks liquidity and needs to be developed. From April 1, 2023, there will be no incremental demand for MFs unless they are able to attract higher yields than fixed deposits. This will further increase the funding costs for corporates as the only major source left for them would be banks," Bardia told CNBC-TV18.com.

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(Edited by : Shoma Bhattacharjee)