Mutual Funds in India are gaining traction all thanks to the bull market conditions prevailing for the last few years especially after 2014. If invested early and in right schemes, Mutual Funds can provide you with long-term wealth. Though the number of subscribers for mutual funds is constantly growing, still lot of people are clueless about what tax benefits accrue to them if they invest in mutual funds. Will one be taxed at exuberant rates or any tax concessions available for investors of mutual fund schemes? Are there any differential rates of income tax for different mutual fund schemes? These are some of the questions that might have been keeping you not to jump the bandwagon of investing in mutual funds. In this post, I will try to explain how the mutual funds are taxed, tax benefits of mutual funds and what are different rates applicable to mutual funds. Let’s begin.
Before we delve into the actual taxation details with respect to mutual funds, I would like to introduce you a concept called ‘Capital Gains’ in income tax. You accrue capital gains when you sell any asset (like land, building, vehicle, house, furniture, machinery, patents, trademarks etc) or investment (shares, bonds etc.,). You generate capital gain when you sell any capital asset at price higher than the purchase price, else you would end up with capital loss. As far as income tax is concerned, only capital gain is pertinent to us. Again capital gains are classified as long-term capital gains and short-term capital gains depending upon the period for which you hold the asset. Let’s say you have a house property which you purchased or constructed in 2014 and sold during financial year 2017-18. Then you will need to pay Long Term Capital Gains (LTCG) (as you held it for more than 24 months) with some concessions like cost of acquisition being indexed to inflation etc . We will discuss the capital gains in detail in a later post. For now let us confine to the basic definition of capital gains and the classification of long-term and short-term capital gains.
Again, mutual funds are broadly classified into equity mutual funds, where at least 65% of portfolio of a mutual fund pertains to domestic equity shares. If not, they are called non-equity mutual funds. There are different methods of taxation for the above two types of mutual funds. Let’s first learn about the income tax on equity mutual funds.
Income Tax on Equity Mutual Funds:
| Particulars | Period of holding of equity mutual fund | Tax |
| Short Term Capital Gain | Less than 12 months | 15% |
| Long Term Capital Gain | More than 12 months | Nil |
As discussed above, equity mutual funds invest more than 65% of their funds in domestic equity shares like large cap funds, small & mid cap funds etc. Hence they are linked to market fluctuations and hence are more volatile. But if held for long-term their returns easily outweigh the traditional forms of investment like fixed deposits, PPFs, RDs etc. Hence to encourage the habit of investing in mutual funds by the general public and to give fillip to domestic industry which in turn will get the funds from these funds, the Government of India has made the tax on profits or returns from the long-term equity funds as Nil. That means if you hold on to an equity mutual fund for a certain minimum period, the returns you generate are completely tax-free. The period is defined by the Government as per Income Tax Act as 12 months. Hence if you hold the equity mutual fund for over 12 months, the gains you get will be classified as long term capital gains and will be fully tax exempt. However if you hold the fund for less than 12 months, then you will be charged short-term capital gain at 15%. While filing Income Tax returns, the LTCG on equity MFs being an exempt income, you need to show it under ‘Exempt Income’ section.
Income Tax on Non-Equity Mutual Funds:
Non-equity mutual funds include liquid funds,ultra short-term, short-term funds, infrastructure debt funds, gold funds etc. The criteria for deciding period of holding for non-equity mutual funds is 36 months. So if you hold on to a non-equity mutual fund for less than 36 months (3 years), you attract short-term capital gains (STCG) on the returns as per your income tax slab. Suppose you are in Rs. 5 lakh- Rs. 10 lakh income tax slab, you need to pay tax @20%, if you are in 2.5L-5L income tax slab, you need to pay STCG of 5% (AY 2018-19) etc. If you hold it for more than 36 months, you need to pay Long Term Capital Gains (LTCG) at 20% with the benefit of inflation indexation else 10% without the benefit of indexation.
Income Tax on Mutual Fund Dividends:
On mutual fund dividends, again different methods of taxation for equity mutual funds and non-equity mutual funds. Dividends issued on equity mutual funds are tax-free both for the investor and for the AMC. However in case of debt mutual funds, while the AMC(Asset Management Company) has to pay a tax known as Dividend Distribution Tax (DDT) on the dividends issued, there is no direct income tax burden on the investor. However, the mutual fund house (AMC) usually deducts the DDT from your NAV and remits the same to the Income Tax Department directly. Currently the rate of DDT stands at 28.84% (25% income tax +12% surcharge + 3% education cess). You can see that you will receive dividends after deduction of DDT which means effectively you will receive only 71.16% of your dividend income. Hence you need to factor in this additional cost when you decide to invest in debt mutual funds with dividend options because of this indirect burden of Dividend Distribution Tax.
Let’s take some general questions posed by investors in Mutual Funds/ Tax Payers:
Q. In debt funds, short-term capital gain (if you invest it for less than 3 years) is mentioned as “tax per your income tax slab” rate. Does it mean that I don’t have to pay anything if my income is less than Rs 2.5 lakhs (currently the base level for income tax) ?
Answer: No, since you are currently non-tax payer, your STCG from debt funds will be tax-free. The moment you cross the annual income of 2.5 lakhs, you will be under 5%, 10%, 20% or 30% slab. When you redeem your debt fund within 3 years, accordingly you need to pay STCG at one of the above rates applicable to you. However if your income from all other sources is less than Rs.2.5 lakhs, and you earn capital gains from debt funds. Then the capital gains will be reduced by the amount by which the other income falls short of the basic exemption limit. For instance if your short term capital gains are Rs.2,50,000 and income from all other sources is Rs.1,00,000, then you will be taxed flat rate of 15% (plus 3% education cess) on Rs.1,00,000 only (Rs.3,50,000-Rs.2,50,000).
Q. I earned returns from mutual funds (equity) which I held for more than 12 months. Should I show it in my income tax return (ITR)?
Answer: Since you have invested in an equity mutual fund and held it for more than 12 months, the tax on such income earned is Nil. However, it is always a good practice to disclose all such exempt incomes in your Income Tax Return in the space provided (Exempt income section) for the same as shown below:
Examples:
1. Mr. A is working as a software engineer in an MNC. His annual income as per previous year’s Income Tax Return is Rs 9,00,000. In April 2014 he started a SIP of Rs 4000 pm in a large cap fund and Rs 1000 pm in a liquid fund. He continued these investments till February 2017. In the month of February 2017, he redeemed his liquid MF fund and large cap fund whose NAVs were Rs 1,60,000 and 40,000 respectively. What is the capital gains tax liability of Mr.A?
Answer: Mr.A held the investments of Large Cap mutual fund and liquid fund for a period of 35 months (April 2014 – February 2017). Since large cap fund being equity mutual fund, his returns on this are tax-free as held it for more than 12 months. So Mr. A doesn’t have to pay anything on Rs. 20,000 capital gains (Rs.1,60,000- Rs.1,40,000) that he made on the large cap fund.
However, Mr. A would have to pay Short Term Capital Gains on liquid fund as he held it for less than 36 months. Since Mr A is in the tax slab of 20%, he would have to pay STCG of 20% plus education cess of 3% on the capital gains (Rs. 40,000-Rs.35,000 = Rs.5,000) which equals to Rs.1030.
2. Mr. B who is working as a manager in a garment manufacturing company earns Rs.8,00,000/- per annum. He invested Rs.1,00,000/- as lump sum in March 2014 in a balanced mutual fund (equity based). He invested Rs. 50,000 lump sum in June 2014. The NAV of this is Rs.75,000/- in April 2017. In this month, he withdrew all his investments in mutual funds. What is the capital gains liability of Mr. B for AY 2018-19?
Answer: Salary income of Mr. B: Rs. 8,00,000/- –> Income tax slab – 20%
Period of holding:
a. equity mutual fund: 36 months
capital gains liability: Nil (being equity mutual fund held for more than a year)
b. Liquid mutual fund: 35 months
Short-term capital gains liability: 20% of (Rs.75,000-Rs.50,000 = Rs.25,000) + 3% education cess: Rs.5150/-
3. Mr C who is working as a consultant in a firm is earning annual salary income of Rs. 4,00,000/-. He invested Rs.1,00,000/- as lump sum in an equity mutual fund with Dividend option during March 2013. The present NAV of the fund as on August 31st, 2017 is Rs.1,60,000/-. During FY 2017-18, he received a dividend of Rs.10,000/-. Find his tax liability?
Answer: Since the fund is an equity mutual fund with Dividend option, neither the investor nor the AMC or the mutual fund house are required to pay any tax.
4. Mr D who is working as a salesman in a product manufacturing company is drawing an annual salary of Rs. 3,00,000/-. He invested Rs.50,000/- in a liquid fund with dividend option in Feb 2013. During the FY 2017-18, he received a dividend of Rs.5,000. Find his capital gains tax liability and the amount his AMC would have deducted before making payment to Mr.D?
Answer: Dividend received: Rs.5,000/-
Since he invested in a non-equity fund with dividend option, the AMC would have to deduct Dividend Distribution Tax (DDT) before making a payment of Rs.5000 to Mr.D. That means, the dividend that Mr. D received is net of the DDT deducted by the mutual fund AMC.
The DDT paid by the AMC (or deducted from Mr. D’s dividend income) is: Rs.5,000*(28.84/71.16) = Rs. 2026.42
Mutual Funds Gains Taxation In case of NRIs:
All the above provisions that we discussed pertains to Indian residents. The taxation in case a non-resident Indian (NRI) invests in Mutual Funds is almost same except that the NRIs will have to shell out TDS on redemption of mutual funds. While the STCG – TDS rates for equity and debt mutual funds are respectively 15% & 30%, the same for LTCG in equity and debt mutual funds are Nil and 20% (with indexation) or 10% (without indexation) respectively.
Mutual Funds Income Tax in case of Joint Holding:
Much like bank accounts, mutual funds also provide you an option either to choose “single”, “joint” or “either or survivor”. Suppose you opt for “joint” holding or “either or survivor” type of joint holding in mutual funds, the obvious question that will arise in your mind is who will be taxed? In such cases, the as far as income tax is concerned, only the first holder is considered. First holder will be the key holder and will remain as the primary holder for all the legal purposes.
PS: Since we are covering about taxation of mutual funds, it is also pertinent to mention here if you subscribe to an Equity Linked Savings Scheme (ELSS scheme), you will get deduction up to Rs.1,50,000/- under section 80C of the Income Tax Act. However, ELSS schemes have a lock-in period of 3 years. Also please note that all equity mutual funds redemptions attract Securities Transactions Tax (STT) of 0.001% when you sell them.