Debt mutual funds do get a preferential tax treatment compared to fixed deposits when it comes to how long-term capital gains are taxed. For such funds, 'long term' is defined as a period that is equal to or greater than 3 years.

When an investment in one of these funds is held for such a period and then sold, profits from such a sale are taxed at a rate of 20% after indexation (essentially, after the rate of inflation in that holding period) has been factored in. Oftentimes, this tends to bring down the rate of tax to low single digit. In recent years, there have even been instances where the entire capital gains have been taken care of by indexation, whereby no tax was owed by investors.

On the contrary, interest earned from fixed deposits are always taxed at the marginal tax rate that an investor belongs to, according to her tax slab. So, unless an investor is in the 0% tax bracket, debt mutual fund investments can yield a higher post-tax return than fixed deposits.

There is a reason that this differential tax treatment is in place. When an investor puts money in a fixed deposit, they are taking practically zero risk since the return is fixed and guaranteed by the institution. On the contrary, debt funds provide no such guarantee and are subject to the returns obtained by fund managers in the debt market. Such risk taking by investors gets rewarded by the government in the form of a beneficial tax regime.

Could the government remove this disparity? It is not outside the realm of possibility, but it is very unlikely. Capital gains have a taxation structure in place that has always been different from how interest is taxed, and this difference is unlikely to be removed since it applies to a wide variety of instruments apart from debt mutual funds. However, even if this disparity is removed, debt mutual funds would still remain a good investment option since they have the potential to provide a better return to the investors. The guarantee that the bank provides comes with a cost that is higher than the fund management cost incurred by a mutual fund investor. This has been borne out by historical returns data. For example, if you had invested in a fixed deposit 2 years ago, it would have fetched a return of 7.5% annually. But, the average short-term debt fund returned 8.3% with good, recommended funds in the category doing even better. As long as mutual funds invest in a wide range of instruments and pass on the returns to you (less a management fee), this return differential will exist. This margin may be high or low at times, depending on prevailing rate scenarios, but it will persist. And, of course, at this time with the preferential tax treatment in place, debt funds are definitely the superior debt investment choice compared to fixed deposits.

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