What is Section 50AA of the Income Tax Act?

Section 50AA, inserted by the Finance Act 2023 and refined by the Finance Act 2024 and Finance Act 2025, classifies certain mutual fund units as 'specified mutual funds' and provides that capital gains from such units are deemed to be short-term capital gains taxable at the investor's slab rate, regardless of the holding period. The provision removed the benefit of long-term capital gains treatment and indexation that was previously available to debt mutual funds held for more than 36 months. The Finance Act 2025 further tightened the rule by lowering the equity threshold from 65 percent to 35 percent for the definition of specified mutual fund.

What is the current definition of a specified mutual fund?

Effective 1 April 2025, a specified mutual fund under Section 50AA is a mutual fund where not more than 35 percent of the total proceeds are invested in equity shares of domestic companies. Funds with 35 percent or less equity allocation are specified mutual funds and are taxed at slab rate as short-term capital gains. Funds with more than 35 percent equity allocation are not specified mutual funds and continue to follow the equity-oriented mutual fund tax regime (12.5 percent LTCG above ₹1.25 lakh after 12 months, 20 percent STCG, under Sections 112A and 111A respectively). The April 2025 amendment narrowed the carve-out, pulling more hybrid and balanced funds into the specified mutual fund definition.

Which funds are now classified as specified mutual funds?

Specified mutual funds include: (a) all debt mutual funds (corporate bond funds, gilt funds, dynamic bond funds, banking and PSU debt funds, ultra short term funds, liquid funds, money market funds, overnight funds), (b) gold ETFs and gold mutual funds (where equity allocation is nil), (c) international equity funds and fund-of-funds investing primarily in foreign equity (where allocation to Indian equity is less than 35 percent), (d) certain hybrid funds with less than 35 percent Indian equity allocation, (e) conservative hybrid funds, (f) most aggressive hybrid funds with more than 65 percent equity continue to be equity-oriented. Arbitrage funds typically maintain more than 65 percent in equity and equity derivatives, so they remain equity-oriented if structured correctly.

Does indexation apply to specified mutual funds?

No. Section 50AA treats all gains from specified mutual funds as short-term capital gains regardless of holding period, taxed at the investor's slab rate. Indexation benefit under Section 48 is not available. This is a material loss for long-term debt fund investors. Under the pre-2023 regime, debt funds held for more than 36 months attracted 20 percent LTCG with indexation, which often resulted in single-digit effective tax for stable-yield debt funds. Under Section 50AA, the same gain is taxed at slab rate (up to 30 percent plus surcharge plus cess), with no indexation.

Does Section 50AA apply to existing units purchased before 1 April 2023?

Yes, but with a grandfathering nuance. Section 50AA applies to mutual fund units acquired on or after 1 April 2023. Units acquired before 1 April 2023 are not specified mutual funds for Section 50AA purposes, even if the underlying fund's equity allocation has since dropped below 35 percent. For pre-1 April 2023 units, the legacy regime applies: 36-month holding period for LTCG, 20 percent LTCG with indexation, slab rate STCG. The cut-off creates two-tier portfolios for long-time debt fund investors, with separate tax treatment for units acquired in different vintages.

How should retail investors restructure portfolios under Section 50AA?

The portfolio re-architecture depends on the investor's marginal tax rate and the alternative product set. For investors at the 30 percent marginal rate, fixed deposits, sovereign gold bonds, and direct corporate bonds now have similar or better post-tax returns than debt mutual funds. The traditional debt fund advantage of LTCG with indexation is gone. For investors at lower marginal rates (5 percent or 20 percent), debt funds remain reasonable. The structural shift favours: (a) direct corporate bonds with TDS at 10 percent, (b) sovereign gold bonds with tax-free maturity, (c) PPF and EPF for long-horizon savings, (d) arbitrage funds for short-term parking (taxed as equity), (e) equity-oriented hybrid funds (above 35 percent equity) for moderate-risk allocation.

Budget 2026 capital gains: Section 50AA and the specified mutual fund tax drag

The two-stage tightening that re-architected debt mutual funds

For two decades, debt mutual funds were the foundational fixed-income product for Indian retail investors. The Long Term Capital Gains tax of 20 percent with indexation, available for units held for more than 36 months, often delivered single-digit effective tax rates on stable-yield gilt funds and corporate bond funds. The post-tax returns competed favourably with fixed deposits, particularly for investors in the 30 percent marginal bracket.

The Finance Act 2023 inserted Section 50AA into the Income Tax Act, 1961, ending this regime for new investments. Effective 1 April 2023, units of debt mutual funds (defined as funds with 65 percent or less equity allocation) acquired on or after that date were classified as "specified mutual funds" and taxed at the investor's slab rate regardless of holding period, with no indexation benefit. The two-tier portfolio cut-off (pre-1 April 2023 units versus post-1 April 2023 units) created an immediate book-keeping discipline for IFAs and tax consultants.

The Finance Act 2025 further tightened the regime by lowering the equity threshold to 35 percent, effective 1 April 2025. This pulled additional hybrid funds and balanced advantage funds into the specified mutual fund definition, removing the equity-oriented tax treatment for several categories that retail investors had previously used for moderate-risk allocation.

This post walks through the Section 50AA framework, the two-stage threshold tightening, the category-by-category impact, and the portfolio re-architecture every retail investor and IFA should run in FY 2025-26.

The legislative framework: Section 50AA

Section 50AA was inserted by the Finance Act 2023 and operative from 1 April 2023. The provision reads, in substance:

"Notwithstanding anything contained in the foregoing provisions of this Act, the capital gains arising from the transfer or redemption or maturity of a specified mutual fund unit shall be deemed to be capital gains from the transfer of a short-term capital asset and shall be charged to tax accordingly."

The definition of "specified mutual fund" was the operative variable. The Finance Act 2023 defined it as "a mutual fund where not more than 35 percent of its total proceeds is invested in equity shares of domestic companies", but this was subsequently amended.

The Finance Act 2024 clarified that for units acquired between 1 April 2023 and 31 March 2025, the threshold is 65 percent equity (i.e., funds with 65 percent or less equity are specified mutual funds). For units acquired on or after 1 April 2025, the threshold is 35 percent equity (i.e., funds with 35 percent or less equity are specified mutual funds).

The Finance Act 2025 retained the 35 percent threshold and finalised the definitional framework.

The two-stage tightening: April 2023 and April 2025

Stage 1: April 2023 (Finance Act 2023). Units acquired on or after 1 April 2023 in a fund with 65 percent or less equity allocation are taxed at slab rate, no indexation, no 36-month LTCG. This affected:

Pure debt funds (always 0 to 30 percent equity): brought into the specified mutual fund net
Conservative hybrid funds (typically 10 to 25 percent equity): brought into the net
Balanced advantage funds (typically 30 to 80 percent equity, dynamic): brought into the net if below 65 percent
Multi-asset funds (typically 35 to 60 percent equity): brought into the net
Gold ETFs and gold funds (zero equity): brought into the net

Equity-oriented funds (more than 65 percent equity) continued to follow the Section 112A regime (12.5 percent LTCG above ₹1.25 lakh after 12 months, 20 percent STCG).

Stage 2: April 2025 (Finance Act 2024/2025). The threshold was lowered from 65 percent to 35 percent. This means:

Funds with 35 to 65 percent equity (which were previously equity-oriented under the 65 percent threshold) are now specified mutual funds, taxed at slab rate.
This pulls in: aggressive hybrid funds with declining equity allocation, multi-asset funds with 35 to 50 percent equity, and certain balanced advantage funds that drift below the new threshold.

The narrowing has been particularly painful for hybrid fund investors who relied on equity-oriented treatment.

Category-by-category impact

Liquid funds and overnight funds. Always 0 to 5 percent equity. Always specified mutual funds. Slab rate tax. Comparable to fixed deposits in post-tax economics. For investors at 30 percent marginal rate, fixed deposits and treasury bills now have similar post-tax returns.

Ultra short term and short term debt funds. Always 0 to 10 percent equity. Always specified mutual funds. Slab rate tax. Loses the indexation cushion that made these attractive for 3 to 5 year horizons.

Corporate bond funds and credit risk funds. Always 0 to 5 percent equity. Always specified mutual funds. Slab rate tax. Compared to direct corporate bonds with TDS at 10 percent, the mutual fund structure is now tax-disadvantaged.

Gilt funds and dynamic bond funds. Always 0 to 5 percent equity. Always specified mutual funds. Slab rate tax. Long-term gilt fund investors at the 30 percent bracket lose materially compared to the pre-2023 indexation regime.

Gold ETFs and gold mutual funds. Zero equity allocation. Specified mutual funds. Slab rate tax. Sovereign gold bonds (SGBs) with tax-free maturity become the dominant alternative for gold allocation.

International equity funds and fund-of-funds. Allocation to Indian equity is typically zero or low. Specified mutual funds under Section 50AA, regardless of underlying foreign equity. Slab rate tax. This was a major surprise for retail investors who used international funds for global diversification.

Conservative hybrid funds. Typically 10 to 25 percent equity. Specified mutual funds even under the pre-April 2025 regime. Slab rate tax.

Aggressive hybrid funds (formerly balanced funds). Typically 65 to 80 percent equity, regulated by SEBI to maintain 65 percent in equity. Continue to be equity-oriented if equity allocation is above 65 percent (some funds may need to maintain above 35 percent to stay out of specified mutual fund net, but the SEBI category definition keeps them above 65 percent in practice).

Multi-asset funds. Typically 35 to 65 percent equity. Hit by the April 2025 lowering. Most multi-asset funds are now specified mutual funds.

Balanced advantage funds (dynamic asset allocation). Equity allocation varies dynamically between 30 and 80 percent. If the equity allocation falls below 35 percent in any month, the fund's tax treatment switches. AMCs have responded by floor-marking equity allocations at 35 percent to maintain equity-oriented treatment, although this defeats the dynamic asset allocation premise.

Arbitrage funds. Typically 65 to 70 percent in equity and equity derivatives. Continue to be equity-oriented if structured correctly. Remain a viable short-term parking option for investors in the 30 percent bracket.

Equity savings funds. Typically 30 to 35 percent equity, 25 to 30 percent debt, 30 to 35 percent arbitrage. The classification depends on the SEBI category definition and the specific equity allocation. Some equity savings funds now classify as specified mutual funds, others as equity-oriented.

The grandfathering: pre-1 April 2023 units

Section 50AA applies prospectively. Units acquired before 1 April 2023 retain the legacy treatment:

Debt funds held for more than 36 months: 20 percent LTCG with indexation under Section 48
Debt funds held for 36 months or less: slab rate STCG
Hybrid funds with more than 65 percent equity: equity-oriented treatment under Section 112A and 111A

The grandfathering creates a two-tier portfolio for long-time debt fund investors. The fund manager must track the acquisition vintage of each unit when computing capital gains on redemption. The mutual fund statement (CAS) clearly identifies the acquisition date for each lot, but the tax computation requires manual lot-by-lot identification.

For SIP investments started before 1 April 2023, the legacy regime applies only to units acquired before the cut-off. SIP installments after 1 April 2023 are under the new regime.

The portfolio re-architecture for FY 2025-26

For an Indian retail investor in the 30 percent marginal bracket, the re-architecture follows these principles.

Replace pure debt funds with direct alternatives.

Fixed deposits with major banks: post-tax return after slab rate matches debt fund post-tax return.
Treasury bills and government securities through the RBI Retail Direct platform: cleaner tax treatment.
Direct corporate bonds (through NSE goBID or bond marketplaces): TDS at 10 percent under Section 193, with the option to claim refund or set off against losses.
Tax-free bonds (NHAI, PFC, REC, IRFC): tax-free interest, available in secondary market.

Replace gold ETFs with sovereign gold bonds (SGBs).

SGB issued by RBI: 2.5 percent annual coupon, tax-free maturity if held to redemption (8-year term), capital gains exemption under Section 47.
SGBs in secondary market: trade through stock exchange, capital gains taxable but indexation eligible.

Replace international equity funds with direct foreign investment.

Use the LRS (₹250,000 per year) for direct US equity through brokers like Vested or Indmoney.
Holdings beyond LRS limits require ODI structuring (see our earlier post on ODI and Form FC-ODI).

Use arbitrage funds for short-term parking.

65+ percent equity allocation, taxed as equity (LTCG 12.5 percent after 12 months above ₹1.25 lakh, STCG 20 percent).
Suitable for 3 to 12 month parking.

Use equity-oriented hybrid funds (above 35 percent equity) for moderate-risk allocation.

Aggressive hybrid funds remain equity-oriented if equity allocation is above 65 percent.
Provides moderate-risk exposure with equity-oriented tax treatment.

Continue PPF, EPF, and NPS for long-horizon retirement savings.

PPF: tax-free interest, tax-free maturity, ₹1.5 lakh annual limit.
EPF: tax-free maturity if conditions met under Section 10(11) and 10(12).
NPS Tier-1: 60 percent tax-free at maturity, 40 percent annuity.

Common errors KAMRIT sees in FY 2025-26 ITR filings

Pre-1 April 2023 SIP units treated under the new regime by mistake (loss of indexation benefit)
International fund redemptions treated as equity-oriented under Section 112A (incorrect, should be specified mutual fund)
Hybrid fund redemptions not re-evaluated under the new 35 percent threshold for April 2025 redemptions
Multi-asset fund SIPs treated as equity-oriented throughout, despite the April 2025 threshold change
Gold ETF redemptions treated as LTCG with indexation (incorrect post-April 2023)
Failure to track acquisition vintage when computing capital gains, leading to incorrect LTCG/STCG classification

Action plan for FY 2025-26

Portfolio audit. Map every mutual fund holding to (a) acquisition date, (b) current equity allocation, (c) specified mutual fund classification.
Vintage segregation. Separate pre-1 April 2023 lots from post-1 April 2023 lots. Track each lot independently for tax purposes.
Reclassification check. For multi-asset and balanced advantage funds, check the equity allocation as of the redemption date against the 35 percent threshold (post-April 2025) or 65 percent threshold (pre-April 2025).
Replace tax-disadvantaged products. Move new allocations from debt funds to direct corporate bonds, treasury bills, or fixed deposits. Move new gold allocation to SGBs.
Maintain ITR computation discipline. Use Schedule CG of ITR-2 or ITR-3 with separate line items for specified mutual funds (taxed at slab) and equity-oriented funds (under Section 112A/111A).
Annual review. With each Finance Act, re-check the Section 50AA definitional changes.

Talk to KAMRIT

KAMRIT's individual income tax desk and our markets-focused HNI advisory team work together to navigate the Section 50AA portfolio re-architecture. We have run tax planning engagements for 400+ HNIs and 1,500+ retail investors through the FY 2023-24 to FY 2025-26 cycle, covering vintage segregation, tax-loss harvesting under the new rules, and the re-allocation roadmap from debt funds to direct fixed-income instruments. For a comprehensive Section 50AA portfolio review, our fixed-fee engagement starts at ₹15,000 for retail and ₹50,000 for HNIs. Reach out at kamrit.in for a free 30-minute portfolio scoping call.

References

Income Tax Act, 1961, Section 50AA (inserted by Finance Act 2023, amended by Finance Act 2024 and Finance Act 2025).
Section 48 (computation of capital gains), Section 112A (LTCG on equity), Section 111A (STCG on equity).
Section 47 (transactions not regarded as transfer) for SGB redemption.
SEBI Mutual Fund Regulations, 1996 (category definitions).
CBDT Circular on Section 50AA (FY 2023-24 and FY 2024-25 clarifications).
Finance Act 2023, Finance Act 2024, Finance Act 2025.