Investors make investments to earn returns on them. When an investment generates returns, it is subject to tax. Therefore, in order to make smart investment decisions, the impact of taxes on investment returns must be taken into account as the ultimate goal of the investor is to keep as much of the returns as possible after paying taxes. Mutual funds are a popular investment choice among many investors and can be a good option for meeting financial goals while giving due consideration to risk tolerance. Thus, it is necessary to know the tax rules related to mutual funds. The tax implications on the returns from mutual funds can vary based on factors such as the type of return, asset class, length of investment and the investor’s residency status. This article delves into the topic of taxation of mutual funds in detail.
Mutual funds are investment vehicles that invest in a variety of options. They are pass-through vehicles, meaning that the income is considered at two levels: the income generated by the fund and the income received by the investor. Hence, both these aspects of taxation must be considered.
Mutual fund schemes invest in securities such as stocks and bonds, which generate income through dividends or interest. In addition, when the fund buys and sells these securities in the market, it may result in capital gains or losses. Interest, dividends and capital gains thus comprise the total income of the mutual fund. In India, mutual funds are structured as trusts for the benefit of unit holders and, as per current tax laws, the income generated by mutual funds is tax-exempt as per the provisions of Section 10(23)(D) of the Income Tax Act.
TYPES OF RETURNS:
Within a mutual fund scheme, investors have two options: the income distribution cum capital withdrawal (IDCW) or dividend option and the growth option. Those who choose the income distribution cum capital withdrawal (dividend) option may receive income in the form of dividends, while investors who opt for the growth plan will not receive any dividends, regardless of the fund's profits. Investors in the growth plan will only realize capital gains or losses when they sell their units, while investors in the income distribution cum capital withdrawal (dividend) plan may receive dividends when declared by the fund and capital gains or losses when they sell their units.
ASSET CLASS:
The Income Tax Act divides mutual funds into two categories: equity-oriented funds and non-equity-oriented funds. A mutual fund scheme is classified as equity-oriented if it holds more than 65 percent of its assets under management in equity shares listed on recognized stock exchanges in India. All other mutual fund schemes are classified as non-equity-oriented for tax purposes.
LENGTH OF INVESTMENT:
Capital gains are divided into two categories: short-term and long-term. The holding period for a long-term capital gain is more than 3 years for non-equity-oriented funds and more than 1 year for equity-oriented funds. Any capital gains made before reaching this holding period are considered short-term capital gains.
The taxation of capital gains from mutual fund investments varies based on the type of mutual fund and the investment holding period. There are two types of capital gains, short-term capital gain (STCG) and long-term capital gain (LTCG), which are defined differently for equity and debt mutual funds. For equity-oriented schemes, a holding period of over 12 months is considered long-term, while for debt mutual funds, a holding period of over 36 months is considered long-term.
In India, profits realised from mutual funds attract capital gain tax for resident investors in the following manner:
Note: In addition to the above, surcharge and cess is applicable. The surcharge is calculated on the base tax and the cess is calculated on the aggregate of base tax and surcharge.
RESIDENTIAL STATUS OF INVESTOR:
The tax treatment for Resident Indian Investors, NRIs and non-individual investors {i.e. Hindu Undivided Family (HUF), Association of Persons (AOP), Body of Individuals (BOI)} may vary. Additionally, in the case of joint holdings, the income, whether it is capital gains or dividends, is considered to have been earned by the first holder.
The taxation rules for mutual fund investments are the same for both resident Indians and non-resident Indians (NRIs), with the only difference being in the method of tax deduction. For resident Indians, there is no tax deducted at source (TDS), while redemptions made by NRIs are subject to TDS at the highest tax rate. For instance, LTCG made in listed debt funds by NRIs is subject to 20% TDS (with indexation benefits), and 10% for unlisted debt funds (without indexation benefits). Dividend income for resident Indians is not subject to TDS, but NRIs are subject to TDS at the highest tax rate, such as 20% TDS for dividend income earned from equity and debt funds.
EQUITY FUNDS:
Equity mutual funds invest a minimum of 65 percent of their assets in equities and equity related instruments, including large-cap, mid-cap, small-cap, multi-cap, sectoral and thematic funds, with the rest in debt and money market instruments. For equity funds, gains from investments redeemed within 12 months from date of purchase are considered short-term capital gains (STCG) and are taxed at 15 percent of the profit. Gains from investments in equity funds held for more than 12 months are considered long-term capital gains (LTCG) and taxed at 10 percent, exceeding Rs 1 lakh. The first Rs 1 lakh worth of LTCG on equity and equity oriented mutual funds is exempt from tax. For instance, if in the financial year 2019-2020 an investor has long-term capital gains of Rs 1.5 lakhs, only Rs 50,000 (Rs 1.50 lakh minus Rs 1 lakh) will be taxed as long-term capital gains @ 10 percent.
This tax rule applies to both tax-saving equity funds and regular equity mutual funds. The only exception is that equity-linked saving schemes (ELSS) have a mandatory lock-in period of three years and therefore, only LTCG tax of 10 percent applies to them. Unlike ELSS, most open-ended equity funds have no lock-in period. It is worth noting that the Rs 1 lakh limit is cumulative for capital gains from all equity investments, including stocks and equity mutual funds.
TAX HARVESTING IN CASE OF EQUITY FUNDS:
Tax-harvesting involves taking advantage of the tax-free limit of Rs 1 lakh to minimize your total Long-Term Capital Gains tax. This is done by selling a portion of your equity investments that have been held for over a year and are classified as long-term, to the extent that the gains do not exceed Rs 1 lakh in a financial year. This process involves redeeming and immediately reinvesting the gains, so that the net investment remains unchanged. By doing so, Rs 1 lakh worth of LTCG is protected from taxation each year. Ultimately, when you sell all your investments, your total tax liability will be lower.
IS TAX HARVESTING A USEFUL STRATEGY TO APPLY?
It is necessary to bear in mind that tax-harvesting has limited benefits because the amount of tax savings it can provide is limited. Regardless of the size of the investment and its growth, the maximum tax savings achievable through tax-harvesting is always capped. In any given year, the maximum tax savings would be 10 percent (the LTCG tax rate) of Rs 1 lakh (the tax exemption limit for LTCG), which is equal to Rs 10,000. This means that the total gains from tax-harvesting would always be limited to this value multiplied by the duration of the investment. For example, over a 25-year period, the maximum possible savings from tax-harvesting would be Rs 2.50 lakhs (Rs 10,000 multiplied by 25), which is always lower than or equal to this amount.
The tax-harvesting strategy also has other difficulties. Investing in equity funds for tax-harvesting purposes requires continuous reinvestment i.e., you must promptly reinvest in equity funds after selling the older units and maintain a large balance in your bank account for the buy transactions. This can result in opportunity loss if the Net Asset Value (NAV) rises before the redemption proceeds are available for reinvestment. Additionally, selling part of your investments annually can be a recurring hassle. Therefore, the effort required for tax-harvesting may not be worth it as the gains are relatively small.
DEBT FUNDS:
Debt funds primarily invest in fixed income securities including bonds, debentures, certificates of deposit and commercial papers. Types of debt funds include liquid funds, short-duration funds, gilt funds, credit risk funds and dynamic bond funds.
Debt mutual funds invest a minimum of 65 percent of their assets in debt securities and money market instruments with a possible small allocation in equities. Short-term capital gains from debt mutual funds, made from investments redeemed within 36 months from purchase, are taxed at the investor's applicable tax rate. Gains from debt investments held for more than 36 months are considered long-term capital gains and are taxed at 20 percent with indexation benefits.
Indexation is the process of adjusting the cost of purchase to account for the impact of inflation. The Cost Inflation Index (CII) is determined annually by the Central Board of Direct Taxes (CBDT). It involves the calculation of the inflation rate between the year of purchase and the year of sale.
For instance, if an investor invested Rs 100,000 in a debt fund in 2019 and sold it in 2022 for Rs 125,000, the capital gain is Rs 25,000 on an investment of Rs 1,00,000 in 3 years. However, tax is not levied on the entire gain, but is adjusted for indexation.
This is done by adjusting the purchase price in the following manner:
Indexed cost of acquisition = Actual cost of acquisition X [CII in the year of sale / CII in the year of purchase]
In our example, indexed cost of acquisition = Rs 1,00,000 X [331/289] = Rs 1,14,533/- The indexed capital gain would be Rs 10,467 (Rs, 1,25,000.00 – Rs. 1,14,533).
The rate of tax on the indexed capital gains is 20 percent and thus the tax liability would be Rs 2,093/-.
As can be seen, this is a reasonably low rate of tax on the capital gain and that too is payable only when the units are sold and the gains are booked.
[Note: The cost inflation index values for the financial years 2019-20 (the year of purchase in our example) and 2022-23 (the year of sale) were 289 and 331 respectively.]
HYBRID FUNDS:
Hybrid funds are mutual funds that invest in both equity and debt securities. This includes funds such as aggressive hybrid funds, conservative hybrid funds, balanced funds, dynamic asset allocation funds and balanced advantage funds. The tax implications for hybrid funds depend on the allocation of assets between equity and debt. If the fund has a higher investment in equities (i.e., if the equity exposure is equal to or more than 65 percent), it will be taxed like equity funds and if the fund has a higher investment in debt securities and equity exposure is less than 65 percent, it will be taxed like debt funds. There are certain hybrid funds such as arbitrage and equity saving funds that are taxed similarly to equity funds, despite having characteristics of debt funds. This can be a tax-efficient option for individuals in the highest tax bracket with a one-year investment horizon.
Apart from taxes, investors should also take into account exit loads when selling their mutual fund investments. For equity funds, the exit load is typically 1% if redeemed before 365 days. For debt funds, the exit load varies based on the category, with overnight and ultra-short duration funds typically not incurring an exit load and a higher exit load for other categories of debt funds.
SYSTEMATIC INVESTMENT PLAN (SIP):
SIP is a method of investing in mutual funds by making periodic investments, which is useful for investors who do not wish to invest a large sum of money at once. This also helps in avoiding market timing. SIPs in equity and debt funds are taxed in the same way as equity and debt funds, with the only difference being that each SIP is considered individually for determining its duration as long-term or short-term. For example, if you start a SIP of Rs 10,000 per month in an equity mutual fund for 12 months, each SIP will be treated as a separate investment. After 12 months, if you sell all your accumulated units, not all the gains will be eligible for LTCG tax, only the gains from the first SIP that has completed one year will be considered LTCG and taxed accordingly. The gains from the rest of the SIPs will be considered as STCG and taxed at a rate of percent.
Until March 31, 2020, dividends from mutual funds were tax-exempt for investors as the mutual fund paid the Dividend Distribution Tax (DDT) prior to distributing the dividends. However, the method of taxing dividends changed in the Budget 2020 and all dividends received on or after April 1, 2020 are added to the investor’s overall income and are taxable as per his/ her individual tax slab and the Dividend Distribution Tax has been abolished.
Besides, starting April 1, 2020, mutual funds are also required to deduct TDS at a rate of 10% on dividend distributions, provided that the annual dividend per recipient exceeds Rs 5,000 in the financial year.
The flowchart below summarizes the tax structure of mutual funds in India.
Conclusion
It is important for mutual fund investors to understand how their investments are taxed. The taxation of mutual funds is not complex and the information provided in this article should provide a better understanding of the different taxes investors may need to pay. Taxes have a cost and every investor should strive to minimize it, but this should not come at the cost of compromising on the quality of the investments. For most retail investors, taxation is not a major concern, but it is still recommended to avoid frequently changing your portfolio as it could lead to an increase in tax liabilities.
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