Clipped from: https://www.financialexpress.com/money/your-money-dividend-taxation-has-now-completed-a-clear-policy-arc-4134073/
Union Budget 2026 proposes a major tax change by disallowing interest deductions on borrowings used to purchase shares and mutual funds.
By Sandeepp Jhunjhunwala
The Union Budget 2026 proposes a fundamental shift in the taxation of leveraged investments by disallowing the deduction of interest on borrowings used to invest in shares and mutual fund units. The proposed amendment marks a clear break from the long-standing tax principle that financing costs incurred in the course of earning taxable income should be deductible.
Since the introduction of dividend distribution tax (DDT) in 1997, dividends were taxed at the company level and remained exempt in the hands of shareholders. Since dividend income was outside the tax net for investors, the question of deducting interest incurred to earn such income did not arise.
Dividends under tax net
This position changed from FY21, when DDT was abolished and dividends were brought back into the tax net. Recognising that earning dividend income could entail financing costs, the law permitted a deduction for interest incurred in relation to dividends and income from mutual fund units, subject to a cap of 20% of the gross income.
This limitation sought to strike a balance, acknowledging legitimate funding costs while ensuring that the door was not left wide open for excessive interest set-offs. Thus, Indian tax law allowed interest on borrowed funds to be deducted where a link was established between the borrowing and the income-earning activity.
This principle applied across business and investment income alike, reflecting the commercial reality that cost of capital is an integral part of generating returns. Budget 2026, however, signals that this settled position is no longer sacrosanct.
Withdrawal of interest deduction
The amendment proposes withdrawal of interest deduction in respect of dividend income and income from mutual fund units, thereby taxing such income on a gross basis.
The apparent policy intent is to curb tax arbitrage in cases where investments were funded through borrowings, interest deductions were claimed and returns were structured predominantly as recurring income rather than capital gains. Interest on borrowings for business or on-lending activities, however, remains deductible. This suggests that tax outcomes are increasingly being driven by the nature of the income earned rather than the genuine purpose of the borrowing.
An additional grey area is whether disallowed interest can be capitalised as part of cost of acquisition and claimed when computing capital gains on sale.
Budget 2026 completes a clear policy arc from exempt dividends under the DDT regime, to limited deductibility once dividends became taxable, and now to a complete denial of interest deduction on investment borrowings.
As the proposal moves towards enactment, clear clarifications, transitional relief and targeted carve-outs will be essential to ensure that the approach remains balanced and effective.
The writer is partner, Nangia Global. Inputs from Sanjay Kumar and Abhishek Mehta
Disclaimer: The views expressed are the author’s own and do not reflect the official policy or position of Financial Express.
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