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Chapter 11 Taxation on Mutual Funds

Mutual Funds have emerged as a key tool for investing for retail and institutional investors. Mutual funds give you the benefit of professional management by trained managers and also the added benefit of diversification as you do not have to worry about security selection. An important aspect of mutual funds that is often missed out is the tax implications. Tax implications on mutual funds arise at four levels and you need to be aware of each of these levels to get a comprehensive view of the taxes levied on returns on your mutual fund investments. Let us look at the four levels:

  • First, there is a tax implication in terms of investments in mutual funds. This is not applicable to all classes of mutual funds but only to Equity Linked Savings Schemes (ELSS) funds. These are special tax saving schemes with a compulsory lock-in period of 3 years. An investment in an ELSS fund entitles you to exemption under Section 80C of the Income Tax Act.
  • Taxation on dividends is the second aspect of mutual funds. Dividends are taxed in two ways. In India, all dividends received by investors from equity and debt funds are tax-free in the hands of the investor. However, both equity and debt funds are liable to pay dividend distribution tax (DDT) at the time of actual payment of dividends. The fund only pays the net amount after deducting the DDT.
  • What happens when you redeem your mutual funds? The difference between the redemption value and the cost is the capital gains. Capital gains are treated differently for equity funds and debt funds based on whether it is short-term gains or long-term gains.
  • Finally, there are other indirect costs that are passed on to you. Securities Transaction Tax (STT) is deducted when you redeem equity funds. There is no STT on debt funds. Similarly, the fund pays STT on its transactions in the market and that gets indirectly passed on to you as part of the Total Expense Ratio (TER) that is debited to your NAV on a daily basis).

CATEGORY 1 – BENEFITS OF TAX-SAVING ELSS FUNDS

ELSS is not only the most efficient tax-saving instrument under Section 80C of the Income Tax Act 1961 but also the most productive over the long run. An ELSS is a diversified equity fund which invests in equity shares of companies belonging to across various levels of market capitalization. Essentially, it is a multi-cap fund with a compulsory lock-in period of 3 years from the date of investment.

The lock-in kicks in on the date of investment. So, if you pay 3 SIPs of an ELSS fund on May 10th, June 10th, and July 10th of 2018, the respective dates on which the lock-in will be completed for these 3 tranches will be May 10th, June 10th, and July 10th of 2021. Each SIP contribution is locked for a period of 3 years from the date of the actual investment. It has nothing to do with the financial year. ELSS contributions can be made in lump-sum or in an SIP format. As long as the investment is made within the financial year, it qualifies for Section 80C.

Further, once you invest in ELSS, you cannot redeem your units before the expiration period of 3 years. To that extent, your funds are locked in. However, the big advantage of ELSS is the 80C benefit that is available as an exemption from your total taxable income. It must be noted that ELSS is just one of the many instruments that qualifies for the overall ceiling limit of Rs1.50 lakh under Section 80C. The actual tax break will depend on how much you are able to claim. For example, if your Provident Fund and Insurance premium are more than Rs1.50 lakhs, there is no incremental benefit from ELSS with respect to tax.

However, if you have no other investments under Section 80C, the entire ELSS contribution becomes tax exempt. For example, if your annual PF contribution is Rs50,000, you can invest Rs1 lakh in ELSS funds, and that is entirely exempt. Let us see how the actual tax treatment of ELSS makes a difference to one’s CAGR over 3 years.

Illustration 1:

Rajiv has a PF contribution of Rs50,000 and decides to invest Rs1 lakh in an ELSS fund to get the full benefit of Section 80C exemption. How exactly does this contribution to ELSS benefit Rajiv and what difference does it make to his returns?

For the sake of simplicity let us assume that while Rajiv invested Rs1 lakh in an ELSS fund, his friend Sanjiv invested a similar amount in a diversified equity fund with the same portfolio. Let us see how their returns differ. Both hold for a period of 3 years:

Particulars Rajiv – ELSS Investment Sanjiv – Equity Fund Investment
Amount invested Rs.1,00,000 Rs.1,00,000
Investment Date March 01st 2015 March 01st 2015
Redemption Date March 04th 2018 March 04th 2018
Redemption Value Rs.1,48,150 Rs.1,48,150
Capital Gains Rs.48,150 Rs.48,150
CAGR Returns (%) 14% 14%
Tax exemption (Section 80C) Rs.1,00,000 N.A.
Effective Rate of Tax (30% tax + 4% surcharge = 31.2%) 31.20% N.A.
Tax saved due to Section 80C Rs.31,200 N.A.
Effective Investment made in 2015 (1,00,000 – 31,200) Rs.68,800 N.A.
Effective CAGR (%) returns after considering tax benefit 29.13% 14%

The illustration above captures how Rajiv benefits from Section 80C. When he invests Rs.1 lakh in ELSS funds, he gets back Rs31,200 as tax benefits. Therefore, his effective investment is now Rs68,800 and not Rs1,00,000. On this smaller investment, Rajiv ends up earning annualized CAGR returns of 29.13% compared to just 14% earned by Sanjiv who had invested the money in a diversified equity fund with no Section 80C tax benefits.

Do note that the above funds were sold on March 04th 2018 before the 10% tax on long term capital gains (LTCG) became applicable. Had these funds been sold after April 01st, then upon redemption after 3 years, the long-term capital gains (LTCG) up to Rs 1 lakh would be tax-free while LTCG in excess of Rs 1 lakh would be taxed at the rate of 10% without the benefit of indexation. We shall dwell on this point in much greater detail when discussing taxation of capital gains for both long term and short term.

CATEGORY 2 – TAXATION OF DIVIDENDS ON EQUITY FUNDS AND DEBT FUNDS

Before we get into the specifics of how dividends are taxed, we need to dwell for a moment on the distinction of equity and debt funds. This classification is critical because equity fund dividends are taxed differently and those on debt funds are taxed differently. SEBI regulations define equity funds as funds with minimum 65% direct exposure to equities on an average period as specified basis. The idea is that for a fund to be classified as an equity fund, it needs have at least 65% of its portfolio invested in equity shares. Otherwise, it is classified as a non-equity fund or a debt fund for the purpose of taxation.

Following are some of the examples of equity funds for tax purposes:

  • Diversified Equity Funds
  • Sectoral Funds
  • Thematic Funds
  • Index Funds
  • Balanced Equity Funds (more than 65% in equities)
  • Arbitrage Funds

Following are some of the examples of non-equity (debt) funds for tax purposes:

  • Liquid Funds
  • Income Funds
  • G-Sec Funds
  • Credit Opportunities Funds
  • MIPs (predominantly invested in debt)
  • Fixed maturity plans (FMPs)
  • Fund of funds

The point to remember here is that the Fund of Funds (FOF) will be treated as a non-equity fund for tax purposes even if it is a fund of equity funds. That is an anomaly which the AMFI has been demanding SEBI to rectify.

Let us first tabulate the applicable rates of tax on dividends for equity and debt funds:

Particulars Individual / HUF Domestic Company NRIs
Tax on Investors on Dividends Received
Equity Funds NIL NIL NIL
Debt Funds NIL NIL NIL
Dividend Distribution Tax (deducted by the fund)
Equity Funds 10% Tax + 12% Surcharge + 4% Cess = 11.648% 10% Tax + 12% Surcharge + 4% Cess = 11.648% 10% Tax + 12% Surcharge + 4% Cess = 11.648%
Debt Funds 25% Tax + 12% Surcharge + 4% Cess = 29.12% 30% Tax + 12% Surcharge + 4% Cess = 34.944% 25% Tax + 12% Surcharge + 4% Cess = 29.12%
Infrastructure Debt Funds 25% Tax + 12% Surcharge + 4% Cess = 29.12% 30% Tax + 12% Surcharge + 4% Cess = 34.944% 5% Tax + 12% Surcharge + 4% Cess = 5.824%

Following points about tax on dividends that needs to be noted:

  • All mutual fund dividends are tax free in the hands of the investor. However, dividend distribution tax (DDT) has to be paid by the fund declaring dividends, which effectively reduces your dividend in hand.
  • Equity funds were not subject to DDT till financial year 2017-18. However, Union Budget 2018 introduced 10% DDT on equity fund dividends.
  • All rates of DDT shown in the above table are effective rates after considering the impact of surcharge and cess applicable to financial year 2018-19 corresponding to the assessment year 2019-20.

To conclude, the dividends declared by equity and debt funds are fully tax free for the investor. However, all categories of mutual funds attract dividend distribution tax (DDT), which reduces the total amount of dividends received by the investor. The credit that you get in your bank account as dividends on your mutual fund holdings is always net of DDT.

CATEGORY 3 – TAXATION OF CAPITAL GAINS ON EQUITY FUNDS AND DEBT FUNDS

When it comes to capital gains, there are a lot more complexities. First, you need to find out whether the fund is an equity fund or a debt fund. We discussed the logic classification of equity funds and debt funds for tax purposes based on the amount of exposure to equities.

This classification is critical as capital gains on equity funds and capital gains on debt funds are treated very differently. When it comes to capital gains, there is an additional complication and that is of the holding period.

The holding period is used to decide whether the capital gain is long-term capital gain (LTCG) or a short-term capital gain (STCG). The rates for LTCG on debt funds, LTCG on equity funds, STCG on debt funds, and STCG on equity funds are all very different. Let us look into each of them.

Mutual Funds Holding Period

The basic motivation behind investing in mutual funds is to earn dividends and capital gains. Capital gains represent the excess of the redemption value over the purchase value and are taxed by income tax authorities. The amount of tax to be paid on capital gains depends on the time for which you stay invested in them. It is referred to as the holding period of mutual funds.

The holding period of mutual fund units can be short-term or long-term. In case of equity mutual funds and balanced mutual funds (with minimum 65% holdings in equities), the holding period of 12 months or more is regarded as long term. In case of debt (non-equity) mutual funds, a holding period of 36 months or more is regarded as long term. A holding period of less than 36 months for debt (non-equity) funds and less than 12 months for equity and balanced funds is defined as short term.

The table below captures the gist of short term and long term durations with respect to equity and debt funds effective financial year 2018-19 corresponding to assessment year 2019-20.

Funds Short-term Long-term
Equity funds Less than 12 months 12 months and more
Balanced funds Less than 12 months 12 months and more
Debt funds Less than 36 months 36 months and more

How are equity-oriented funds taxed?

It needs to be remembered that LTCG on equity funds were tax-free till March 31, 2018. It is only from April 1, 2018, onwards that LTCG on equity funds are being taxed at a flat rate of 10%. There will be a basic exemption of Rs1 lakh available, and any profits above that during a financial year will be taxed at a flat rate of 10%. By flat, it means there will be no indexation benefit irrespective of holding period. Short-term capital gains on equity funds will continue to be taxed at the old rate of 15%.

The table below provides a gist of the tax rates:

Particulars Individual / HUF Domestic Companies NRIs
Equity Oriented Schemes
Long Term > 12 months | Short Term < 12 months
Long Term Capital Gains (LTCG) up to Rs1 lakh in a year Nil Nil Nil
Long Term Capital Gains (LTCG) beyond Rs1 lakh in a year 10% 10% 10%
Short Term Capital Gains (STCG) 15% 15% 15%

Let us understand this concept of long-term gains calculation in greater detail:

Long-term capital gains on sale of equity shares/units of equity-oriented fund - if the capital gain is more than Rs1 lakh, tax rate is 10% without the benefit of indexation. However, there is relief to existing investors for tax exemption of capital gains up to Jan 31, 2018. The amount of gains made thereafter this cut-off date will be taxed.

Illustration 2

Tarun purchased shares worth Rs100,000 on 30th September, 2017, and sold them on 31st December, 2018, at Rs120,000. The value of the holding was Rs110,000 as on 31st January, 2018. Out of the capital gains of Rs20,000 (i.e., 120,000-100,000), Rs10,000 (i.e. 110,000-100,000) is not taxable. The balance will be taxed at 10%. This formula is only available for shares bought prior to 31st January, 2018. Any shares purchased after that date will not have this benefited extended to them.

Remember, there is no benefit of indexation available in case of equity funds even if the shares are sold after 20 years. The 10% flat tax on LTCG has to be paid on any annual LTCG beyond Rs1 lakh.

How are debt (non equity)-oriented funds taxed?

Short-term capital gains (STCG) on debt funds are added back to your income and taxed at your peak rate of tax which could be 20% or 30% as the case may be. Here, STCG on debt funds is that which is held for less than 3 years. Long-term capital gains on debt funds are taxed at the rate of 20% after indexation.

Indexation is a method of factoring in the rise in inflation between the year when the debt fund units were bought and the year when they are sold. Check out the tabulated tax table below:

Particulars Individual / HUF Domestic Companies NRIs
Debt Oriented Schemes
Long Term > 36 months | Short Term < 36 months
Long Term Capital Gains (LTCG) 20% with indexation 20% with indexation 20% with indexation for listed and 10% for unlisted stocks
Short Term Capital Gains (STCG) 30% 30% 30%

Let us understand indexation in greater detail…

Indexation is a protection given by the income tax department against inflation. Each year, the IT department announces the index value. The table below captures the gist of index values for last 18 financial years.

Index Values announced by Income Tax Department (Base is 2001-12)
FY 2001-02 FY 2002-03 FY 2003-04 FY 2004-05 FY 2005-06 FY 2006-07
100 105 109 113 117 122
FY 2007-08 FY 2008-09 FY 2009-10 FY 2010-11 FY 2011-12 FY 2012-13
129 137 148 167 184 200
FY 2013-14 FY 2014-15 FY 2015-16 FY 2016-17 FY 2017-18 FY 2018-19
220 240 254 264 272 280

Using the index table is quite simple. If you bought a debt fund in FY 2013-14 at Rs100 and sold in FY 2017-18 at Rs160 then your indexed cost of acquisition will be Rs.123.66 (100 x (272/220). Thus you will have to pay the 20% LTCG tax on the debt fund on the indexed capital gains which is Rs.36.34 (160-123.66). Thus, indexation helps you reduce your tax outflow by giving you the benefit of cost inflation indexation (CII).

How are balanced funds taxed for capital gains?

The taxation rules only recognize equity funds and non-equity funds. If the proportion of equity is more than 65% then the balanced fund is an equity fund otherwise it is a debt fund for tax purposes. There is no separate tax rule for a balanced fund, other than using the portfolio mix to determine if the fund is equity-oriented or debt-oriented.

Does the taxation of SIP differ from lump-sum investments for capital gains?

An SIP (systematic investment plan) is a method of investing a fixed amount in a mutual fund in a periodic manner. An SIP can be fortnightly, monthly, quarterly, or yearly. Gains made from SIPs are taxed as per the type of mutual fund and holding period. For the purpose of taxation, each individual SIP is treated as a fresh investment and gains on it are taxed separately.

Suppose you begin an SIP of Rs10,000 a month in an equity fund for 12 months. Each SIP is considered to be a fresh investment. At the end of 12 months, if you decide to redeem your entire accumulated corpus (investments plus gains), all your gains will not be tax-free. Only the gains earned on the first SIP would be tax-free because only that investment would have completed one year. The rest of the gains would be subject to short-term capital gains tax.

For the purpose of calculation of capital gains on SIPs, the First in First out (FIFO) method is used, where the units acquired initially are assumed to be sold first followed by others in a chronological order.

CATEGORY 4 – STT AND MISCELLANEOUS TAXES ON MUTUAL FUNDS

Apart from these, the Securities Transaction Tax (STT) is levied on mutual funds. An STT of 0.001% is levied by the fund company itself when you sell units of an equity fund or balanced fund. There is no STT on the sale of debt fund units. In addition, the mutual fund pays STT on the equities that it buys and sells in the market. These taxes are indirectly passed on to the unit holders through the total expense ratio (TER). The loading is not direct, but it is present nevertheless.

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