One Stop Guide On Mutual Fund Taxation

When it comes to understanding the taxation aspect in mutual funds, it certainly is not rocket science. In this article we will explain how mutual funds are taxed in a more understandable form 

When it comes to investments, a lot of people focus on returns followed by taxation. Better tax treatment is one of the core reasons why a lot of life insurance policies get sold. And they get sold not just from the tax deduction (under section 80 C of Income Tax Act) point of view, but also because there is no tax on the gains. According to the 2018-19 Annual Report from Insurance Development Authority of India (IRDAI), as of March 2019, the assets under management (AUM) of the life insurance industry stood at Rs 35.33 lakh crore of which Rs 4.11 lakh crore or 11.65 per cent is contributed by ULIPs alone.

Whereas, the mutual fund industry AUM stood at Rs 23.8 lakh crore in the same period. This clearly shows how people are more inclined towards insurance as an investment avenue. Although, to have a level playing field with mutual funds, it has been proposed in the recent budget to levy capital gains tax on Unit Linked Insurance Plans (ULIP) with collective premium above Rs 2.5 lakhs. However, other traditional polices such as endowment plan and money-back policies are still out of the purview of taxation. Therefore, taxation becomes one of the deciding factors for people before committing their funds.

There are many other avenues that compete with insurance as investment. Mutual fund is one such investment avenue where it gives tax-efficient returns and helps you achieve your financial goals. Investing in fixed deposits is a great disadvantage, particularly if you fall under the highest tax bracket, as the returns are added to your overall income and taxed as per your slab rate. And here mutual funds score better. But still many a times people shy away from understanding how mutual fund gains are actually taxed as they feel it’s quite technical in nature. And often enough, people make the wrong investment decisions just to save on taxes. However, when it comes to understanding the taxation aspect in mutual funds, it certainly is not rocket science. In this article we will explain how mutual funds are taxed in a more understandable form.

Earning from Mutual Funds

In order to understand taxation on mutual funds, we first need to be very clear about how you earn from mutual funds. As an investor in mutual funds, you earn in two ways: dividends and capital gains. Dividends are nothing but a regular source of income provided by the mutual fund schemes from the gains on investments made by you. Mutual fund investors receive dividends proportional to the number of units held by them. Further, one needs to understand that it is at the discretion of the asset management companies (AMC) whether or not to pay dividends.

On the other hand, capital gain is the profit realised by mutual fund investors by selling or redeeming the units of the held mutual fund. Say, for instance, you invested Rs 10,000 and at the time of selling the value is Rs 20,000 then Rs 10,000 (Rs 20,000 less Rs 10,000) becomes your capital gain. However, one thing to note here is that from the tax point of view only realised gains are considered. Moreover, both dividends as well as capital gains are taxable in the hands of mutual fund investors.

"Inflation is taxation without legislation."
- Milton Friedman

Taxing the Dividends

Previously, dividends were tax-free in the hands of investors as mutual funds used to pay Dividends Distribution Tax (DDT) before disbursing the dividends to investors. However, as per the amendments made in the Union Budget 2020, dividends offered by any mutual fund scheme are taxed in the hands of mutual fund investors. This means that dividends received by investors should be added to their overall income and must be taxed as per their respective income tax slab rates.

Taxing Capital Gains

Capital gains are usually divided into two parts: long-term and short-term capital gains. Therefore, before understanding how capital gains are taxed, we need to understand how the longterm and short-term capital gains are defined.

The above table clearly help us understand how different mutual funds have different long-term and short-term capital gains definition. From the taxation point of view, the mutual funds are divided into two major types - equity mutual funds and debt mutual funds - wherein anything below 12 months is short-term and above 12 months is long-term for equity mutual funds and anything below 36 months is short-term and above 36 months is long-term for debt mutual funds. However, we do have hybrid funds as well where it is a mix of equity and debt. Therefore, to determine their long and short term we need to look at its equity and debt component. If at all times a hybrid fund has 65 per cent or more of equity then it is considered to be an equity fund and if 65 per cent or more is in debt then it is considered a debt mutual fund. Further, the arbitrage fund which again comes under the hybrid category is usually considered to be an equity fund for taxation unless it has 65 per cent or more in debt securities.

Taxing Equity Mutual Funds

As said earlier, from the taxation view point, any fund which has 65 per cent or more invested in equities is deemed to be an equity fund from the taxation perspective. Therefore, referring to the table alongside, if you sell an equity fund before 12 months then it would be considered as short-term capital gains and would be taxed at 15 per cent plus cess irrespective of your income tax slab. And if you sell an equity fund after 12 months, then gains up to Rs 1 lakh are exempt.

This means that if your long-term capital gains are below Rs 1 lakh then you don’t have to pay any tax. But if they are above Rs 1 lakh then it will attract 10 per cent plus cess (without any indexation benefit) on the gains above Rs 1 lakh. For instance, if your long-term capital gains in Rs 80,000 then you don’t have to pay any tax, but if it is Rs 1,20,000 then you need to pay tax of Rs 2,000 (10 per cent of Rs 1.2 lakh less Rs 1 lakh).

Taxing Debt Mutual Funds

From the tax purview, debt mutual funds are those where 65 per cent of the assets are dedicated towards debt securities. Hence, referring to the table alongside, if you redeem units of debt mutual funds before 36 months, then it would be considered as short-term capital gains and would be added to your overall income to be taxed as per your income tax slab rates. However, if you sell debt funds post 36 months then it would attract 20 per cent tax with indexation benefit. Indexation is nothing but the adjustment of your purchase value for inflation. The gains are calculated after deducting this inflated purchase value from the sales value. This reduces your gain (not actually but for taxation purpose) and hence, you need to pay less tax. In order to calculate the same, Cost Inflation Index (CII) is used, which is released every financial year.

Taxing the SIPs

The systematic investment plan (SIP) is one of the ways of investing in mutual funds and it is designed in such a way that investors can invest a small sum periodically - daily, weekly, monthly, quarterly, bi-annually or annually. For every SIP that you make, you actually purchase a certain number of units of that fund and the redemption of these units is carried out on a first-in-first-out basis.

Thus, if you are investing in an equity fund through a monthly SIP for one year and you decide to redeem all your investment after 13 months, the units purchased through the SIP in the first month would be considered to be long-term and you realise long-term capital gains on these units. If these gains are less than Rs 1 lakh, then you don’t have to pay any tax. However, the rest of the units have not yet completed 12 months. Hence, you make short-term capital gains on those units purchased. These gains would be taxed at a flat rate of 15 per cent plus cess, irrespective of your tax slab.