SEBI’s mutual fund switch proposal raises an old question: easier exits, or easier churn?

SEBI wants to make it easier for mutual fund investors to switch schemes without paying capital-gains tax. Wealth managers see merit in the idea. But they are less sure it will improve investing discipline.

SEBI has recommended that a switch from one mutual fund scheme to another should not be treated as a taxable sale if the investor has held the units for more than a year. The proposal was first reported by Reuters. It forms part of SEBI’s pre-Budget representations and is not binding.

Under current rules, selling units of an equity-oriented mutual fund to move into another scheme can trigger capital-gains tax. The money remains invested in the market, but the switch is treated as a redemption followed by a fresh purchase. For units held beyond 12 months, gains above Rs 1.25 lakh in a financial year are taxed at 12.5%. The rate was raised from 10% in July 2024.

The case for relief

The tax can delay a sensible decision. An investor may stay in an underperforming fund simply to avoid a large tax bill.

“There are instances where investors continue holding an underperforming scheme because they are averse to a significant tax liability,” said Deviprasad Nair, chief business officer at Helios India.

Debasish Mohanty, MD and chief strategy officer at The Wealth Company Mutual Fund, said the concern is especially relevant for investors with large gains in older equity funds. Since even a move between schemes of the same fund house is treated as a redemption and fresh purchase, tax can deter investors from exiting mismatched funds or rebalancing.

“Many investors therefore stay in underperforming or mismatched funds simply to defer tax,” he said.

Nair said taxation is not usually the primary reason investors avoid switching. But it can influence the timing and extent of portfolio changes. When accumulated gains are large, the immediate liability can become a meaningful deterrent.

Feroze Azeez, joint CEO at Anand Rathi Wealth, has a different experience. Tax has not been a major deterrent for his clients, whose portfolios are reviewed annually and changed infrequently.

Still, Azeez said tax should not dictate portfolio decisions. “Tax should be one of the considerations when reviewing a portfolio, rather than the deciding factor,” he said.

Who gains most?

The relief may matter more to investors with large, unrealised gains. The existing Rs 1.25 lakh annual exemption helps smaller investors. Larger portfolios can exceed it quickly.

Azeez said HNIs and larger retail investors could benefit more because their gains often exceed the annual exemption. Nair agreed that the benefit would be greater in absolute terms for HNIs.

Mohanty added a distinction: HNIs may gain more in rupee terms, but retail investors could benefit from greater flexibility to adjust portfolios as goals, risk appetite and asset allocation change.

“Retail investors could gain considerably through improved portfolio flexibility and long-term investment discipline,” he said.

The impact may also vary by fund type. Azeez said investors in thematic or sectoral funds may find tax-neutral switching particularly useful, as the case for exiting such funds can change with market cycles.

The churn question

The bigger question is behavioural. Will investors use tax-free switching to correct a portfolio, or rotate into whichever fund performed best last year?

Azeez said the relief could lead to more frequent switching if safeguards are absent. “Such frequent changes could encourage investors to chase recent returns rather than stay invested in line with their financial goals,” he said.

Nair noted that frequent switching does not necessarily lead to better outcomes and can disrupt long-term compounding.

Mohanty said the proposal should enable disciplined changes—such as replacing consistently underperforming schemes, consolidating fragmented portfolios or adjusting risk levels—rather than short-term performance chasing.

“The objective should not be to encourage frequent switching based on short-term performance,” he said.

What safeguards may be needed

Experts favour treating the relief as a tax deferral rather than a permanent exemption. The original purchase cost and holding period would carry forward, with tax payable when the investor eventually exits the mutual fund system.

Azeez suggested a 12-month minimum holding period, same-PAN eligibility and direct movement of money between schemes. Nair recommended a qualifying period and a cap on the number of annual switches, with initial eligibility limited to equity-oriented schemes.

Mohanty went further: gains should be calculated from the date of first investment, not the switch date, to prevent repeated tax-free movements. He also called for clear reporting so the cost base carries forward correctly, and for excluding structures that could be used for tax avoidance.

He also flagged a basic gap: the Income-tax Act does not define a “switch”. It is unclear whether the relief would cover only moves within a fund house or also redemption from one fund house followed by investment in another.

The difference is simple. An exemption makes mutual funds easier to trade. A rollover removes the penalty for correcting a portfolio while preserving the eventual tax liability.