Taxation in Mutual Funds – How Mutual Funds are Taxed ?

The profits you generate out from your Mutual Fund Investments are termed as Capital Gains.

Mutual Funds are taxed based on the gains you make from the capital you had invested. So if you suffer a loss – No Tax. I know suffering a loss is not someone wants just to save tax but people do it for setting off their other capital gains. We will discuss this concept later in the article. Let’s start with the basics.

The taxation structure of Mutual Funds is based on the category and the Holding Period which decided what is your Capital Gains.

Table 1. Taxation of Mutual Funds

Equity Funds:

If the Investments holding period is less than 12 months they are treated as Short Term Investments and if it is more than 12 months they are treated as Long Term Investments. So, Capital Gains on Short Term Investments are known as Short Term Capital Gains (STCG) and on Long-Term Investments is known as Long Term Capital Gains (LTCG)

Short Term Capital Gains (STCG) in Equity Funds are taxed at 15%. Long Term Capital Gains (LTCG) in Equity Funds are taxed at 10% if the gains are above Rs.1 lakh (Rs.1,00,000). Long Term Capital Gain less than 1 lakh are not taxed in Equity Funds i.e. you would not have to pay tax if your long term gain is less than 1 lakh.

Dividend in Equity Mutual Funds:

Dividends from Equity Mutual Funds are tax-free. But, there is a catch. Dividends from Equity Mutual Funds are paid after deducting a Dividend Distribution Tax(DDT) of 11.648% which is inclusive of surcharge and cess. DDT is paid by the Mutual Funds and not the investors but it ultimately leads to reducing the returns for investors.

Grandfathering Clause in Equity Mutual Fund Taxation:

The Grandfathering save investors who have made equity investments before 31st January 2018 (before the LTCG on Equities came into effect) from any unfair tax deductions.

Grandfathering allows the people to hold on their privileges after a certain rule is came into effect. For the ones who join later, they would be abiding by the new rule

To understand this let us consider the below scenarios:

Case 1:

Purchase before Jan 31, 2018 NAV:       Rs. 50

Price on Jan 31, 2018:                            Rs.100

Sale after Jan 31, 2018 NAV:                  Rs.150

Since the purchase NAV is higher than the price on Jan 31, the Capital Gains is 150 – 100 = Rs.50

Case 2:

Purchase before Jan 31, 2018 NAV:      Rs. 50

Price on Jan 31, 2018:                           Rs.100

Sale after Jan 31, 2018 NAV:                 Rs.50

Here, though the Price on Jan 31 is higher than the purchase price, the investor would not have any Capital Gains and hence no taxes (Told you Grandfathering is fair!)

Case 3:

Purchase before Jan 31, 2018 NAV:      Rs. 150

Price on Jan 31, 2018:                           Rs.100

Sale after Jan 31, 2018 NAV:                 Rs.250

Here the Purchase price is on the higher side than the Price on Jan 31. Therefore, the purchase price would be considered and the Capital Gains would be 250-150 i.e. Rs.100

Thus, the Grandfathering clause makes the game fair to the investors who have made equity investments before 31st January 2018 before the LTCG on Equities came into effect.

Balanced Funds:

Since Balanced funds keep 65% or more into Equity they are considered as an Equity Oriented scheme and taxed as an Equity Scheme.

Arbitrage Funds:

Arbitrage Funds which try to gain from the opportunities arising from the cash and derivatives market are taxed just like the equity funds.

Debt Funds:

If the Investments holding period is less than 36 months they are treated as Short Term Investments and if it is more than 36 months they are treated as Long Term Investments.

Short Term Capital Gains in Debt Funds are taxed according to your income tax slab. Whereas, Long Term Capital Gains in Debt Funds are taxed at 20% after indexation.

Indexation takes into account the inflation from when you purchased the units to the time you redeem it. The logic behind indexation is not to consider the gains which are being taken away due to inflation and tax but on what is the real profit.

Let’s see an example to understand it better. When you redeem your money from debt funds after 3 years, then the taxation of 20% is only on the returns which are more than the inflation. This is done so that your income is adjusted with inflation. The benefit of indexation thus leads to payment of less capital gains tax and at times when the inflation is equal to your returns then no capital gains tax.

Dividend in Debt Mutual Funds:

Dividends from Debt Mutual Funds are tax-free in the hands of the investors. But dividends from Equity Mutual Funds are paid after deducting a Dividend Distribution Tax(DDT) of 29.12% which is inclusive of surcharge and cess thus reducing the returns for investors.

International Funds:

For taxation purposes, the International Funds which invest in stocks abroad and Funds of Funds which invest in different mutual funds are considered as debt funds. Therefore, the tax rules which apply to these funds are similar to that of debt funds.

ELSS Funds:

ELSS funds are the schemes investing in which come under the Sec 80C of the Income Tax Act 1961. The maximum benefit from 80 C is of Rs.1,50,000 in a financial year. ELSS Schemes have a lock-in period of 3 years from the date the investments were made. For SIPs the 3 years is calculated for each and every SIP being made into the scheme.

ELSS Funds are Equity funds and hence their taxation is according to other equity funds. That means that after  3 years when you wish to redeem the investments, any Gains are subjected to the LTCG Taxation as in Equity.

See Top 5 Equity Linked Saving Schemes.

Taxation For NRIs:

When it comes to NRIs they are subjected to TDS(Tax Deducted at Source) for their gains made from Mutual Funds, unlike the resident individuals. However, they file for the returns and lower their tax burden if possible which would be subjected to their income slab and the DTAA(Double Tax Avoidance Agreement) which the Indian authorities might have with the country they reside in.

Set Off Capital Loss

Mutual Funds are taxed only on the gains and not losses. If you incur a loss, it is a Capital Loss which can be divided into a Short Term Capital Loss (STCL) or a Long Term Capital Loss (LTCL) depending on the holding period and the category of the mutual fund (refer Table 1)

The taxation structure does allow you to benefit from any losses you have made by setting off from your capital gains. During the time of Returns Filing, you have to disclose under which head does your income fall. One such head is – Capital Gain. Capital Loss can only be set-off against the gains which come under the Head of Capital Gains.

The rules to Set Off Capital Loss are:

Short Term Capital Loss can be set off against both Short Term or Long Term Capital Gains.

Long Term Capital Loss can be set off only against Short Term Capital Gains.

If you are unable to set off the capital loss in the current year, you can carry forward both the Long Term Capital Loss as well as the Short Term Capital Loss for 8 assessment years after the year in which the loss was computed.