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All you need to know about mutual funds taxation

16 Jan 2020

Mutual funds are considered to be a tax efficient form of investment compared to other instruments; and rightly so. However, there are several layers to it. Once we understood these properly, we can make a very effective use of this investment option for our benefit. Let us look at the finer aspects of mutual fund taxation in India. 

Equity versus non-equity funds

The key to taxation of mutual funds in India is based on whether the fund in question is an equity fund or a non-equity fund. According to the Income Tax Act, a mutual fund scheme is classified as an equity fund if the proportion of holdings in equities is above 65%. Thus, your typical large cap funds, mid cap funds, index funds, sector funds and even arbitrage funds will classify as equity funds for taxation purposes. All funds that do not fall in the above category of equity funds are classified as non-equity funds. This distinction has larger implications for the taxation of dividends and capital gains.

Taxation of dividends on mutual funds

Dividends are taxed differently based on the types of mutual funds. Let us look at equity funds first. In the case of equity funds, the dividends are entirely tax free in the hands of the mutual fund investor. However, effective Budget 2018, the dividends paid by equity funds are subject to dividend distribution tax (DDT) at the rate of 11.648% (10% DDT + 12% surcharge + 4% cess). This reduces the amount of dividend received.

In the case of non-equity funds, the DDT is much steeper. Dividends paid out by debt funds, liquid funds and income funds are subject to DDT at the rate of 29.12% (25% DDT + 12% surcharge + 4% cess). This is almost at par with the peak income tax rates payable. Hence it is advisable to opt for a growth plan and structure a systematic withdrawal plan (SWP) rather than opting for dividend plans of debt funds.

Taxation of capital gains on mutual funds

Capital gains are the profits made when the sale price is higher than the cost price. Let us look at equity funds first. In case of equity funds, gains are classified as long term if held for 1 year or more and as short term gains if held for less than 1 year. STCG is taxed at 15% plus cess, which makes it 15.6%. Long term capital gains on equity funds were tax free till April 2018. Effective Budget 2018, LTCG on equity funds are taxed at 10% flat on the annual gains in excess of Rs.1 lakh. Flat tax means; even if you hold the equity fund for 10 years, there is no benefit of indexation available.

In case of non-equity funds or debt funds; gains are classified as long term if held for 3 years or more and as short term gains if held for less than 3 years. STCG is taxed at your peak tax rate applicable since it is added to your other income. In the case of long term capital gains on debt funds, they are taxed at 20% flat but with the benefit of indexation. One can also structure purchases in late March and sale in early April to get benefits of dual indexation.

Tax rebate for ELSS funds

This is a special category of equity oriented funds that offer tax exemptions under Section 80C subject to a lock-in period of 3 years. The funds cannot be withdrawn during this 3 year lock in period. The Section 80C continues to offer a blanket upper limit of Rs.1.50 lakhs and ELSS is part of this overall limit. What is interesting is that this enhances the effective yield on ELSS funds. For example, if you are in the 30% tax bracket and if you contribute to ELSS then you get a 30% tax break on the contribution. When you invest Rs.100, you are effectively investing only Rs.70. When the yields are calculated on Rs.70 instead of Rs.100, you can see the differential benefits of an ELSS due to the tax break.

Write-offs and carry forward of losses

Finally, just as profits on mutual funds are taxed, losses can be written off against profits. Obviously, capital losses can only be set off against capital gains (no other head of income). Short term losses can be set off against long term and short term gains while long term losses can only be set off against long term gains. In addition, any unabsorbed losses can be carried forward for a period of 8 assessment years, subsequent to the year when the losses arose.

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All you need to know about mutual funds taxation

16 Jan 2020

Mutual funds are considered to be a tax efficient form of investment compared to other instruments; and rightly so. However, there are several layers to it. Once we understood these properly, we can make a very effective use of this investment option for our benefit. Let us look at the finer aspects of mutual fund taxation in India. 

Equity versus non-equity funds

The key to taxation of mutual funds in India is based on whether the fund in question is an equity fund or a non-equity fund. According to the Income Tax Act, a mutual fund scheme is classified as an equity fund if the proportion of holdings in equities is above 65%. Thus, your typical large cap funds, mid cap funds, index funds, sector funds and even arbitrage funds will classify as equity funds for taxation purposes. All funds that do not fall in the above category of equity funds are classified as non-equity funds. This distinction has larger implications for the taxation of dividends and capital gains.

Taxation of dividends on mutual funds

Dividends are taxed differently based on the types of mutual funds. Let us look at equity funds first. In the case of equity funds, the dividends are entirely tax free in the hands of the mutual fund investor. However, effective Budget 2018, the dividends paid by equity funds are subject to dividend distribution tax (DDT) at the rate of 11.648% (10% DDT + 12% surcharge + 4% cess). This reduces the amount of dividend received.

In the case of non-equity funds, the DDT is much steeper. Dividends paid out by debt funds, liquid funds and income funds are subject to DDT at the rate of 29.12% (25% DDT + 12% surcharge + 4% cess). This is almost at par with the peak income tax rates payable. Hence it is advisable to opt for a growth plan and structure a systematic withdrawal plan (SWP) rather than opting for dividend plans of debt funds.

Taxation of capital gains on mutual funds

Capital gains are the profits made when the sale price is higher than the cost price. Let us look at equity funds first. In case of equity funds, gains are classified as long term if held for 1 year or more and as short term gains if held for less than 1 year. STCG is taxed at 15% plus cess, which makes it 15.6%. Long term capital gains on equity funds were tax free till April 2018. Effective Budget 2018, LTCG on equity funds are taxed at 10% flat on the annual gains in excess of Rs.1 lakh. Flat tax means; even if you hold the equity fund for 10 years, there is no benefit of indexation available.

In case of non-equity funds or debt funds; gains are classified as long term if held for 3 years or more and as short term gains if held for less than 3 years. STCG is taxed at your peak tax rate applicable since it is added to your other income. In the case of long term capital gains on debt funds, they are taxed at 20% flat but with the benefit of indexation. One can also structure purchases in late March and sale in early April to get benefits of dual indexation.

Tax rebate for ELSS funds

This is a special category of equity oriented funds that offer tax exemptions under Section 80C subject to a lock-in period of 3 years. The funds cannot be withdrawn during this 3 year lock in period. The Section 80C continues to offer a blanket upper limit of Rs.1.50 lakhs and ELSS is part of this overall limit. What is interesting is that this enhances the effective yield on ELSS funds. For example, if you are in the 30% tax bracket and if you contribute to ELSS then you get a 30% tax break on the contribution. When you invest Rs.100, you are effectively investing only Rs.70. When the yields are calculated on Rs.70 instead of Rs.100, you can see the differential benefits of an ELSS due to the tax break.

Write-offs and carry forward of losses

Finally, just as profits on mutual funds are taxed, losses can be written off against profits. Obviously, capital losses can only be set off against capital gains (no other head of income). Short term losses can be set off against long term and short term gains while long term losses can only be set off against long term gains. In addition, any unabsorbed losses can be carried forward for a period of 8 assessment years, subsequent to the year when the losses arose.