Please note – With the proposals detailed in the 2018-19 budget, the rules regarding equity fund taxation as explained in this article do not apply any longer. Click here for the updated rules regarding long-term capital gains tax on equity funds.
If there is one detail regarding investment that everyone pays close attention to, it is taxation. Here’s putting down what you need to know about taxes and your funds.
While much of your other income, such as salary or interest income, is taxed at your slab rate, the gains you receive from mutual funds – called capital gains – have separate taxation provisions. They are called capital gains tax. Since taxation is a vast topic, even while considering only mutual funds, we’ll cover it in two parts.
What is MF capital gain?
Capital gain is simply the profit on your investment when you sell your mutual fund units. It is the difference between the market value of your mutual fund units at the time of sale and the cost of such units. The gains come in from the appreciation in your fund’s NAV.
Capital gains can be short term or long term, depending on how long you hold the fund units. Holding period is the number of years between when you first bought a unit and sold it. What is considered short-term and long-term holding varies between equity and debt/gold mutual funds.
In this article, we will look at how capital gains tax applies to equity mutual funds and debt funds. In the next one, we shall see how the taxes are calculated when you buy and sell at multiple points.
Tax on equity funds
Taxation rules on equity and equity-oriented funds are fairly simple. A holding period of more than 12 months qualifies as long-term holding; less than that is short term.
Equity-oriented funds have no tax on long-term capital gains; i.e., if you sell your fund after 12 months from the date you bought it, you don’t pay capital gains tax. On short-term holding, the capital gains tax is a flat 15 per cent, no matter which tax bracket you belong to. Securities transaction tax (at 0.001%) will apply on all redemptions of equity schemes. That is about one paisa for every Rs 1000 of redeemed money and hence ignorable.
All dividends from equity funds are exempt from tax, irrespective of when you receive it.
To qualify as an equity-oriented scheme as per tax rules, the fund should have at least 65 per cent of its portfolio in domestic equity shares on an average. By this definition, equity-oriented balanced funds are also tax-free after a one-year holding period, just like equity funds. They are also taxed at 15 per cent for short-term capital gains. Similarly, arbitrage funds and equity savings funds are also treated as equity for tax purposes.
International funds that invest in the stocks of other markets such as the US or Europe, will not be an equity fund as they do not hold domestic stocks to the extent of 65% (as required by tax laws). Equity fund-of-fund schemes do not enjoy the tax benefits of equity funds because they don’t hold stocks; they hold other funds.
Tax on debt funds
Debt funds, as a category, include liquid, ultra short-term, short-term, income accrual, dynamic bond, and gilt funds. It also includes all debt-oriented funds as MIPs and other hybrid non-equity funds. International funds and gold funds also follow the same taxation as debt funds.
For these funds, short-term is a holding period of less than 36 months. Long-term holding is a period more than 36 months. On short-term capital gains, you are taxed at your slab rate. That is, if you’re in the 20% tax bracket, you pay 20% of your capital gains as tax. If you’re in the 10% tax bracket, you pay 10% tax on your capital gain.
On long-term capital gains, your tax is 20% of the gain with cost indexation benefits. Indexation is the method by which your cost is adjusted for inflation. What this does is to effectively reduce your absolute gain, as your cost goes up and thus reduces your taxable profit. (We’ll do a detailed post on indexation soon!)
While equity funds do not suffer tax on dividend, debt funds do! You do not pay this tax – called dividend distribution tax (DDT). The AMC deducts it from your NAV and remits it directly. So you receive dividend net of DDT.
The DDT rate for individuals at present is 28.84% (including surcharge and cess). Do note that as dividends are paid out from your NAV, your NAV falls post such dividend payout or reinvestment. Hence, the capital gains, if any, when you sell your units under this option will seem lower. But the fact remains that you paid tax on the dividend, which is nothing but part of your profit.
Hence, it is important for you to know whether it is suitable for you to opt for dividend option in debt, depending on your tax profile. We will do a separate article on how to optimally use the dividend and growth option.
Who pays the tax?
If you are a resident Indian, the fund house will not deduct any tax (TDS) when you sell your units. You are required to show the income and pay taxes, if any, when you file your returns. If you are a non-resident Indian, while the tax laws remain the same for capital gains, TDS will be deducted, at the applicable rates, when you sell your units.
Remember that any transaction that involves units going out of your holding qualifies as redemption. So if you’re switching units from one scheme to another or from the dividend to growth option (or vice versa), or making a systematic transfer plan or a systematic withdrawal plan, they’re all redemptions.