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Chapter 12 Taxation On Non-Equity and Debt Oriented Assets

When it comes to taxation on investments in India, there are a few basic categories that are considered. For example, there is a distinction between financial assets and real assets. Real assets are those assets backed by physical existence and tangibility like land, building, property, gold, jewellery, etc. Then there are financial assets that either depict a statement of ownership or a statement of claims and include equity shares, bonds, mutual funds, ETFs, gold bonds, etc. This is the primary basis for differentiating the taxation of assets.

The second basis for classification of assets is within the category of financial assets, where the classification is between equity and debt (ownership versus claims). While the classification is quite clear in case of equity shares or bonds or government debt, the classification can be quite tricky when it comes to mutual funds. That is because there are mutual funds that hold both equity and debt in their portfolio. So what do we classify them as?

Such mutual funds are classified as equity or debt-based on their exposure to equities at a prescribed point of time. For example, any mutual fund with an exposure of 65% or more to equities will be classified as an equity mutual fund for the sake of taxation. Consequently, diversified equity funds, index funds, sectoral funds, arbitrage funds and balanced equity funds are classified as equity funds. All other mutual funds are classified as non-equity or debt funds. In this chapter, we shall look at the finer aspects of taxation of non-equity financial assets and shall, inter alia, include the following:

  • Debt funds
  • Savings accounts
  • Fixed deposits
  • Taxation on income from other sources

1. How are debt funds taxed?

Debt funds, as a category, include liquid, ultra-short-term, short-term, income accrual, dynamic bond, and gilt funds. It also includes all debt-oriented funds as monthly income plans (MIPs) and other hybrid non-equity funds. Interestingly, all international funds and gold funds also follow the same taxation as debt funds. In fact, a fund of funds (FOF), even if it is a fund of equity, is classified as a debt fund for taxation purposes.

Debt funds: Long-term and short-term capital gains

In the case of debt funds, short-term is a holding period of less than 36 months, while long-term holding is a period more than 36 months. (This cut-off was 12 months till the Union Budget 2014.)

Short-term capital gains are taxed at your applicable slab rate. This means that STCG gets added to your total income and you are taxed depending on the slab of income you fall in (10%, 20%, or 30%). While the 4% cess will be automatically applicable, in case the income of the individual filing the returns is more than Rs50 lakh or Rs1cr for the financial year, then an additional surcharge of 10% and 15%, respectively, will also be imposed. For this purpose, the STCG will be considered to be a part of total income.

In the case of debt funds, long-term capital gains are taxed at 20% of the gain with cost indexation benefits. Indexation is the method by which your cost is adjusted for inflation. What this does is it effectively reduces your absolute gain as your cost goes up and thus reduces your taxable profit. We will see this aspect of the impact of indexation later in this module.

Taxation of dividends on debt funds

Debt funds pay out dividends in case you opt for the dividend plan instead of a growth plan. While debt fund dividends are tax-free in the hands of the investor, the dividends are subject to dividend distribution tax (DDT), which is deducted by the company before the amount is paid out to the investor. DDT not only entails the flat rate of tax but also surcharge and cess on top of that.

Let us understand the actual impact of DDT on dividends paid out.

Illustration 1:

Elixir Bond fund is paying out dividends to its debt fund holders at the rate of Rs4 per unit on the debt fund. Mahesh holds 1,000 units of the Elixir Bond fund. How much dividend does he actually earn?

Let us see the actual effect of the gross and the net dividends paid out by Elixir Bond Fund:

Particulars Calculation Amount
Units held by Mahesh -- 1,000
Dividend declared Rs.4 per unit Rs.4,000
Calculation of DDT (Rate of tax @25% * surcharge @12% * Cess @4%) 29.12%
DDT on dividends (4,000 x 29.12%) Rs.1,165
Net dividends received by Mahesh Rs.2,835

As can be seen from the above illustration, the DDT tends to reduce the net dividends in the hands of the investor. Such DDT deducted from the dividends has to be deposited by the fund into the government treasury within a period of seven days from the payment of the dividend.

Indexation benefits on Debt Funds

One of the advantages of debt funds when we calculate long-term capital gains is that it gives us the added benefit of indexation. Now, what does indexation mean? It is the compensation for an increase in the cost inflation index (CII). The Income Tax department announces the CII number and the relevant numbers are as under.

Check the table on index numbers below:

Index Values announced by Income Tax Department (Base year is 2001)
FY01-02 FY02-03 FY03-04 FY04-05 FY05-06 FY06-07
100 105 109 113 117 122
FY07-08 FY08-09 FY09-10 FY10-11 FY11-12 FY12-13
129 137 148 167 184 200
FY13-14 FY14-15 FY15-16 FY16-17 FY17-18 FY18-19
220 240 254 264 272 280

These index numbers above are the guide that all individuals paying capital gains must use for indexing. When you buy in a particular financial year and sell in another financial year (beyond a period of three years to qualify), you must multiply the original cost of acquisition by the selling year index number and divide by the buying year index number. The result will be the indexed cost of acquisition which will be higher than the original cost of acquisition. You only need to pay capital gains tax on the indexed value of capital gains which is the difference between the selling value and the indexed cost of acquisition. Let us see how this will work.

Illustration 2:

Let us say, you purchased a debt fund (growth plan) in September 2010 worth Rs64 lakh and sold the debt funds at Rs127 lakh in Sept 2017, then here is how your capital gains will be calculated for tax purposes after imputing the benefit of indexation.

Particulars Amount Indexation Amount
Cost of Purchase Rs.64 lakh Actual Capital Gain Rs.63 lakh
Month of Purchase Sept 2010 Indexed Cost of Buy
{63*(272/167)
Fiscal Year FY10-11 Rs.103 lakh
Sale Value Rs.127 lakh Sale Value Rs.127 lakh
Month of Sale Sept 2017 Indexed Capital Gain Rs.24 lakh
Fiscal Year FY17-18 Tax at 20% Rs.4.80 lakh

In the above Illustration, the taxable capital gains come down from Rs63 lakh to Rs24 lakh, and the tax paid is just Rs4.80 lakh. The effective tax paid on LTCG on the sale of debt funds, therefore, works out to just 7.6% (Rs.4.80 lakh/Rs.63 lakh). This is the benefit that indexation proffers to investors when calculating the taxation on capital gains.

There is an interesting thing to understand, especially after the Union Budget 2018-19, which imposed a flat 10% on equity fund LTCG without the benefit of indexation. On the contrary, the LTCG on debt funds actually qualifies for indexation as explained above. Let us look at how a typical debt fund will fare vis-à-vis an equity fund due to this difference in indexation benefit?

One can argue that equity funds and debt funds are not exactly comparable as they are different products altogether. That is not the point. The real point to note is that debt funds get the benefit of indexation while equity funds do not. How does that change the equation? Let us look at a live illustration with a five-year timeframe.

Illustration 3:

Debt Fund Amount Equity Fund Amount
Date of Investment May 01, 2013 Date of Investment May 01, 2013
Amount Invested Rs.10,00,000 Amount Invested Rs.10,00,000
CAGR Yield 12% CAGR Yield 12%
Date of Redemption May 01, 2018 Date of Redemption May 01, 2018
Redemption Value Rs.17,62,342 Redemption Value Rs.17,62,342
Capital Gains Rs.7,62,342 Capital Gains Rs.7,62,342
Indexed Value of purchase (280/220) Rs.12,77,273 Exempt LTCG Rs.1,00,000
Indexed LTCG Rs.4,85,069 Taxable LTCG Rs.6,62,342
LTCG at 20% Rs.97,014 LTCG Tax at 10% Rs.66,234
Post-Tax LTCG Rs.3,88,055 Post-Tax LTCG Rs.5,96,108

While the equity fund has still done better than the debt fund in post-tax terms despite indexation for debt funds, the LTCG benefit of equity funds is diminishing. Here are two points that logically follow:

  • The above equation would have been strongly weighted in the favour of equity funds had the 10% tax on equity fund LTCG not existed. That has largely taken away the tax attractiveness of equity funds vis-à-vis debt funds in the long run.
  • For simplicity, we have assumed that the equity fund and the debt fund generate the same return, which is not the case in reality. The message is that now equity funds will have to sharply outperform the debt fund returns to compensate for the loss of tax and indexation benefits on equity funds.

Hence, it is important for you to know whether it is suitable for you to opt for dividend option in debt funds, depending on your tax profile.

Is there Tax Deduction at Source (TDS) on debt funds?

If you are a resident Indian, the fund house will not deduct any tax (TDS) when you sell your units. You are required to show the income and pay taxes, if any, when you file your returns. If you are a non-resident Indian (NRI), while the tax laws remain the same for capital gains, TDS will be deducted, at the applicable rates, when you sell your units. Remember that any transaction that involves units going out of your holding qualifies as redemption. So if you’re switching units from one scheme to another or from the dividend to growth option (or vice versa), or making a systematic transfer plan or a systematic withdrawal plan, they’re all redemptions for the purpose of tax calculation.

Debt funds’ tax implications

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 of Sebi to rectify.

Let us tabulate the applicable rates of tax on dividends for different investors on debt funds:

Particulars Individual / HUF Domestic Company NRIs
Tax on Investors on Dividends Received
Debt Funds NIL NIL NIL
Dividend Distribution Tax (deducted by the fund)
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%

2. How is interest income on a savings accounts taxed?

Interest that gets accumulated in your savings bank account must be declared in your tax return under income from other sources. In this case, the bank does not deduct TDS on savings bank interest. However, interest from both fixed deposit and recurring deposits is taxable while interest from savings bank account and post office deposits are tax-deductible to a certain extent. But they are shown under income from other sources.

Interest income from a savings bank account or a fixed deposit or from a post office savings account are all shown under this head.

Deduction on interest income under Section 80TTA

For a residential individual (age of 60 years or less) or HUF, interest earned up to Rs 10,000 in a financial year is exempt from tax. The deduction is allowed on interest income earned from the following:

  • Savings account with a bank
  • Savings account with a co-operative society in business of banking
  • Savings account with a post office

Senior citizens are not entitled to benefits under section 80TTA.

3. How are fixed deposits (FDs) taxed?

Fixed deposit interest that you receive is added along with other income that you have such as salary or professional income, and you’ll have to pay tax on that income at a tax rate that’s applicable to you. TDS is deducted on interest income when it is earned, though it may not have been paid. For example, the bank will deduct TDS on interest accrued each year on a FD for five years. Therefore, it is advisable to pay your taxes on an annual basis instead of doing it only when the FD matures.

Senior citizens, with effect from April 01, 2018, will enjoy an income tax exemption up to Rs.50,000 on the interest income they receive from fixed deposits with banks, post offices, etc., under Section 80TTB.

How do you avoid TDS on FDs?

Banks are required to deduct tax when interest income accrued from deposits held in all such bank accounts a is more than Rs.10,000 in a year. A 10% TDS is deducted if PAN details are available. It is 20% if the bank does not have your PAN details, so always make it a point to ensure that your PAN is registered with the bank.

TDS deducted on FD interest is explained in Form 26AS. The document can either be accessed through your NSDL account or through your registered Income Tax login /daccess or even via your internet banking account which is mapped to your income tax PAN card.

If your total income is below the taxable limit, you can avoid tax deduction on fixed deposits by submitting Form 15G and Form 15H to the bank requesting them not to deduct any TDS. While senior citizens above the age of 60 are required to submit Form 15H all other tax payers can submit this declaration in Form 15G.

These forms are for residents only and for those whose taxes add up to zero. These forms must be submitted at the start of the financial year. If you missed submitting them then the TDS will be deducted by the bank. Of course, you can claim a refund by filing an income tax return at the end of the financial year. Remember that these forms are valid for one year and hence they must be submitted each year to keep banks from deducting tax.

Reporting Fixed Deposit and Recurring Deposits in Your Tax Return

  • If you have three FDs open, then add up all the interest income and enter it under “Other interest income”.
  • Starting June 2015, when interest income from all the branches of the bank including from recurring deposits, exceeds Rs10,000 in a financial year, a 10% tax on interest earned will be deducted. The interest earned should be shown in “income from other sources.

4. Miscellaneous heads of non-equity income

There are a few basic things to know about some specific categories of income arising from various non-equity sources.

  • The PPF and EPF amount you withdraw after maturity is exempt from tax and must be declared as exempt income from income from other sources. Note that: The EPF is only tax exempt after five years of continuous service.
  • If you are collecting pension on behalf of someone who is deceased, then you must show this income under ‘income from other sources’. There is a deduction of Rs.15,000 or one-third of the family pension received, whichever is lower, from the Family Pension Income. This will be added to the taxpayer’s income and tax must be paid at the applicable rates.
  • If you win the lottery or an online/TV game show, it will also be taxable under the ‘Income from other Sources’ head. This income will be taxable at the flat rate of 30%, which will amount to 30.9% after adding cess.
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