MUTUAL FUND TAXATION (India)
To maximize returns from an investment, it is essential to understand the different sources of returns associated with an instrument and the related taxation implications. In case of mutual fund (MF) investments, there are two primary sources of return:
a) Dividends: these are periodic payments made to the investors who opt for the dividend plan.
b) Capital Gains/losses: this is the difference between the acquisition value and redemption value of mutual fund units.
The profit arising out of sale or redemption of MF units is classified as capital gain and is subject to taxation. These gains can be classified as short term capital gains (STCG) or long-term capital gains (LTCG) depending on 'Holding Period'. The tax so levied is referred to as 'Capital Gains Tax' and is based on- residential status (Resident v/s NRI), type of fund and duration of investment.
Types of Mutual Funds
In India, mutual funds are divided into two categories:
1) Equity Oriented Mutual Funds are schemes which invest at least 65% of its corpus into equity and equity related instruments. Large-Cap funds, Small-Cap funds, Sectoral funds, Balanced funds (equity oriented), Arbitrage funds are some of the categories of equity oriented mutual funds. (Arbitrage mutual funds which invest in arbitrage opportunities in cash and derivatives segment of equity markets, are treated as equity funds for the purpose of taxation).
2) Non-Equity Oriented Mutual Funds are schemes which invest less than 65% of its corpus in equity and equity related instruments. Liquid funds, Debt Funds, Infrastructure Funds, Gold Funds, Balanced Funds (deb-oriented) etc. are all examples of non-equity oriented mutual funds.
Taxes On Mutual Funds
Capital gains on MF schemes can be classified as either short-term or long-term, depending on the investment horizon.
1) Equity Oriented Mutual Funds
Any gains made by selling or redeeming equity oriented mutual fund investments before twelve months from date of investment are treated as short-term capital gains (STCG). Currently, short-term gains in equity oriented mutual fund investments are taxed at 15% irrespective of the investor's income tax slab.
Alternatively, gains made by holding equity oriented mutual funds for more than 12 months are treated as long term capital gains (LTCG) and are not taxable up to Rs 1 lakh. LTCG in excess of Rs 1 lakh is taxed at the rate of 10% without indexation benefit. Moreover, for any investments made in equity oriented mutual funds or shares before January 31, 2018, gains until that day will be considered as grandfathered and exempt from tax.
There is a special category of Tax Saving funds within equity oriented mutual funds called Equity Linked Savings Scheme (ELSS). These funds have a lock-in period of 3 years. However, by investing in ELSS, you can claim tax deduction up to Rs 1.5 lakhs under Section 80C. Upon redemption after 3 years, the long-term capital gains (LTCG) up to Rs 1 lakh are tax-free. LTCG in excess of Rs 1 lakh is taxed at the rate of 10% without the benefit of indexation. Readers may note that starting FY 2020-21 (AY 2021-22), the deduction u/s 80C shall only be applicable to those opting for the existing tax regime. Deductions u/s Section 80C are not available under the new tax regime. Click for more.
2) Non-Equity Oriented Mutual Funds
In case of non-equity oriented mutual funds or debt funds, the holding period for defining short term capital gains is three years. For funds classified in this category, any gains made by selling or redeeming investments before 36 months are classified as short-term capital gains (STCG) and taxed as per investor’s income tax slab rate.
On the other hand gains by selling or redeeming non-equity oriented mutual fund or debt fund investments after 36 months is classified as long-term capital gains (LTCG). Currently long-term gains in non-equity oriented mutual fund or debt fund investments are taxed at 20% with inflation indexation benefit on the cost.
Understanding Inflation Indexation Benefit
Indexation is a method of factoring in the rise in inflation between the year when the fund units are bought and the year when they are sold. Indexing the cost of investments brings the original acquisition cost to at an inflation adjusted current value by using the consumer price index. To put it simply, cost of your original investment is increased by the amount of inflation during the holding period thus reducing the tax liability.
Let us see how it works with the help of an example:
Suppose Mr. X invested Rs. 50,000 in a debt fund that delivered 8% annualized return over 5 years. The value of the investment after 5 years would thus increase to Rs 73,466. If he sells his investment after 5 years the investment qualifies for indexation benefit. The new indexed cost will be calculated as: (Original investment cost*consumer price index in the year of sale)/consumer price index in the year of purchase. Let us assume CPI was 497 in the year 2005-06 and 407 in the year 2000-01. So the indexed cost will be: 50,000*497/407 = Rs. 61,970. Therefore long-term capital gain is 73,466 – 61,970 = Rs. 11,496 and tax on this is 20%*11,496 = Rs. 2,300.
As seen from the example above, indexing the cost of investment to inflation reduced the taxable gain (originally, 73,466-50,000 = Rs. 23,466 to Rs. 11,496) by increasing the cost of investment, therefore reducing Mr. X’s capital gain tax liability.
Taxation of Dividends
There are two important aspects to taxation of dividends: the dividend distribution tax and the income tax on dividends. Budget 2020 has altered the mechanism for taxation of dividends by abolishing the dividend distribution tax. Thus, to correctly understand their tax liability for a given year, readers must note the changes that shall be applicable starting FY 2020-21.
Until FY 2019-20, dividends from both equity and non-equity oriented mutual funds are tax-free in the hands of investors but are subject to different rates of dividend distribution tax for the mutual funds company, which reduces the in-hand return for investors as detailed below:
Equity Oriented Mutual Funds: dividends are tax-free in the hands of investors but are paid after deducting a dividend distribution tax (DDT) of ~11.65% (including surcharge and cess).
Non-Equity Oriented Mutual Funds: dividends received are tax-free in investor’s hands. However, mutual fund company has to pay a dividend distribution tax (DDT) of 29.12% (including cess and surcharge) before distributing it to investors.
In contrast to this, starting FY 2020-21, the dividend distribution tax shall not be applicable on any category of mutual funds. Instead, dividends as received from either equity oriented mutual funds or non-equity oriented mutual funds shall be taxed in the hands of the investors at the applicable income tax slab rate. Further, tax shall be deducted at source on. TDS shall be levied at the rate of 10% if the dividend income exceeds Rs 5,000 in a given financial year.
Tax treatment for Resident Indians v/s Non-Resident Indians (NRIs)
The STCG and LTCG taxes are same for Resident Indians (Indian investors) and NRI’s. The only difference is that in case of NRI investors, the STCG and LTCG is applied at the time of redemption. For Resident Indian investors, tax is not deducted at the time of redemption rather the gain has to be disclosed in the income tax returns and applicable tax has to be paid accordingly.
