Taxation of Mutual Fund Investments

Introduction

These days' Mutual funds are being considered as one of the most popular and convenient investment option as it helps the individual to achieve his or her financial goal at the time of need. Generally, Mutual funds are termed as tax saving instruments. Investment of funds in a fixed deposit is considered as greatest disadvantage if the individual taxpayer is falling under the highest slab of income tax as the interest will be added to his total taxable income and will be taxed at a higher income tax slab rate.  On the other hand, Mutual funds are far better option as the score is better as compared to the investment is fixed deposit. When a investment is made in a mutual fund, there is a benefit or advantage of effective tax returns and expert money management.

 How Returns are earned when investments are made in Mutual Funds?

Mutual funds provide return in the following two forms to its investors;

• Dividend
• Capital Gains

Dividend:

Basically, dividends are paid out of the company’s profits if any. In case the companies have surplus cash left then they may decide to distribute the same with the investors in dividend form. In such case, investors get proportional dividends according to the units of mutual funds held by each of them.

Capital Gain:

Capital gain refers to realization of profits by the investors in case the security selling price is more than the purchase price held by them. In simple words, the capital gains are realized as a result of the appreciation in the mutual funds unit price. 

 It is to be noted that dividends as well as capital gains are taxable on the end of investors of mutual funds under the provisions of Income Tax Act, 1961.

Taxation of Dividends Earned by Investment in Mutual Funds

According to the changes and amendment  made in the Union Budget 2020,  any dividends provided under the mutual fund scheme are taxed as per the provisions of Income Tax Act, 1961.  This simple means that the dividends received by the investors is added to the total taxable income of the investor and taxed according to their respective income tax slab rates.

Before the aforesaid provisions, dividends received by investors were tax free as the companies used to pay Dividend Distribution Tax (DDT) prior to sharing of the profits with the investors in the form of dividends. Under the aforesaid regime, dividends received up to 10 lakh per annum from domestic companies were tax free on the end of the investor. Any dividend received that is more than 10 Lakh per annum in a particular financial year is subject to Dividend Distribution Tax at the rate of 10%.

Taxation of Capital Gains Offered by Mutual Funds

Basically, the rate of taxation for capital gains earned through mutual funds depends on the holding period of the mutual funds. The holding period of mutual funds is the duration of holding of mutual funds unit by the investor. It simply means that the holding period is the time duration between purchase and sale date of mutual funds units. A table containing the details of categories of capital gains earned due to sell of mutual funds unit is provided below;

It is to be noted that both short-term and long-term capital gains are taxed are different rates under the provision of Income Tax Act as offered by mutual funds.

Taxation of Capital Gains earned through Equity Funds

Equity funds are the mutual funds the portfolio of which is equity exposed exceeding 65%. As mentioned earlier, the realization of short-term capital gains for redemption equity funds units within the specific holding period of 12 months. The aforesaid gains are taxable under a flat rate of 15% irrespective of the income tax slab.

The gains can be realized on sale of long-term capital gains on equity funds units after the holding period is more than 12 months. It is to be noted that the capital gains less than Rs. 1 lakh are exempted from tax.  A long term capital gain exceeding the prescribed limit is subject to Long term Capital Gain Tax (LTCG) at the rate of 10% and the advantage of indexation is not provided.

Taxation of Capital Gains earned through Debt Funds

Debt funds are the mutual funds the portfolio of which is debt exposed exceeding 65%.  As mentioned earlier in the table, the redemption of short term capital gains on the debt units within a holding period of more than 36 months. The aforesaid gains are added to the total taxable income of the taxpayer and the same is taxed as per the respective income tax slab rate.

Long-term capital gains are earned when the debt funds are sold after a period of holding it for more than 36 months. The aforesaid gain is also taxed at flat rate of 20% after indexation. Apart from that, cess and surcharge on tax will also be imposed on the same as applicable.

Taxation of Capital Gains earned through Hybrid Fund

The taxation rate of capital gains on balanced or hybrid funds is clearly based on the exposure of the portfolio of the equity. In case the equity is exposed more than 65%, then the fund scheme is taxable just like an equity fund and if not then the taxation rules for debt funds will not be applicable.

Thus, it is important to know the exposure of equity of the hybrid scheme that the individual wants to invest, if not then the individual will land in trouble at the redemption of the fund units. A table summarizing the taxation rate of capital gains on mutual funds is furnished below;

Taxation of Capital Gains If the investments are made Through SIPs

Systematic Investment Plans otherwise known as SIPs are considered as methods for investment in mutual funds.  SIPs are designed in a manner that a small amount can be invested periodically by an investor in a mutual fund scheme.  In this investment, investors are provided the opportunity and authority to choose the investment frequency. The frequency can be monthly, weekly, quarterly, annually or bi-annually.

There are certain mutual funds units which can be purchased through the installment of SIPs.  The redemption of these mutual units can be processed on first-in and first-out basis. This can be better analyzed with the help of an illustration. For example, if an investment is made in an equity fund through SIP for 12 months, then the same can be redeemed entirely after a period of 13 months.

In this case, the mutual funds units are bought through SIP are held for longer period i.e. more than 12 months or 1 year, then capital gain realized for sale of the same will be considered as long term capital gain. In case the long term capital gains are less than Rs. 1 lakh then there is no need to pay tax.

However, realization of short term capital gains are made on the mutual funds units bought through SIPs from the investment of 2nd months and onwards.  Irrespective of the income tax slab, the capital gains are taxable at flat rate of 15%. Apart from that applicable cess and surcharge will be applicable on the taxable amount.

Securities Transaction Tax (STT)

Apart from the tax on capital gains and dividends, another tax known as Securities Transaction Tax (STT) is charged according to the provision of the Income Tax Act, 1961. A Securities Transaction Tax of 0.001% is imposed by the Ministry of Finance, in case of buy and/or sell of mutual funds units of a hybrid-oriented fund or an equity fund. It is to be noted that there is no Securities Transaction Tax on sale of debt mutual funds units.

Conclusion

From the above analysis and explanation, it can be concluded that the longer the holding of the mutual funds, the more tax effective they will become. The tax on the long term capital gains is relatively lower as compared to the tax on short-term gains.