Tax on Mutual Funds – A Complete Guide

Deepesh Khatri
Deepesh Khatri
deepesh.n.khatri@gmail.com

Mutual Funds have gained popularity as an investment avenue over the last decade with the increase in the average Assets Under Management from Rs. 5.41 trillion in July 2008 to Rs. 23.06 trillion in July 2018. It is important for investors to know the taxability of mutual funds under the Income Tax Act, 1961. Herein we will discuss the mutual fund taxation, the impact of redemption/sale of mutual funds and tax benefits of investments in mutual funds.

Factors Determining the Mutual Fund Taxation

Before determining the tax rate applicable to mutual funds, we need to understand the factors that determine the mutual fund taxation. They are as follows;

a. Investors Residential Status needs to be determined as per Income Tax Rules for each individual investor:
• Resident
• Non-Resident (NRI)

b. Type of Mutual Fund to be determined on the basis of the market in which corpus is invested:
Equity Fund – 80% or more corpus invested in equity
Hybrid Fund/Balanced Fund – 60% or more corpus invested in equity
Debt Fund – all other mutual funds

c. Holding Period of Investment to be determined by the type of mutual fund:
• Short Term
• Long Term

How Mutual Funds are Taxed?

A. Categorization of Mutual Fund Taxation

Type of Mutual Fund Holding PeriodCategory of Tax
Equity Fund and Hybrid Fund/Balanced Fund< 12 months (less than twelve months)Short Term Capital Gain/Loss
> 12 months (greater than twelve months)Long Term Capital Gain/Loss
Debt Fund< 36 months (less than 36 months)Short Term Capital Gain/Loss
> 36 months (greater than 36 months)Long Term Capital Gain/Loss

Note: The capital gain/loss amount of a mutual fund is calculated by deducting the investment amount from the redemption/sale value. So if an investor puts in Rs. 10,000/- in a mutual fund and then redeems/sells it for Rs. 12,000/-, the capital gain of that investor would be Rs. 2,000/-. If the same mutual fund is instead redeemed/sold by the investor for Rs. 9,000/-, then the capital loss of that investor would be Rs. 1,000/-.

B. Tax Applicable on Mutual Funds

The charts and scenarios below can summarize the mutual fund taxation applicable on redemption/sale of mutual funds and their prevalent rates.

Capital Gains Tax on Equity and Hybrid/Balanced Mutual Fund

Category of TaxRate of Tax
ResidentNon-Resident (NRI)
Long Term Capital Gain10% (if the capital gain in the year is above Rs. 1 lakh)
Short Term Capital Gain15%

Suppose an investor has only one investment and that is equity or a hybrid/balanced mutual fund. Let us examine the tax applicable to it in various scenarios.

Scenario 1

Long Term Capital Gain on an Equity/Hybrid/Balanced Mutual Fund During the Year Up To Rs. 1 lakh – The investor puts in Rs. 10,00,000/- in the mutual fund and then redeems/sells it for Rs. 10,80,000/-, the capital gain would be Rs. 80,000/- and it will be taxed at a rate of 0%.

Scenario 2

Long Term Capital Gain on an Equity/Hybrid/Balanced Mutual Fund During the Year Greater than Rs. 1 lakh – The investor puts in Rs. 10,00,000/- in the mutual fund and then redeems/sells it for Rs. 11,20,000/-, the capital gain would be Rs. 1,20,000/- and it will be taxed at a rate of 10%.

Scenario 3

Short Term Capital Gain on an Equity/Hybrid/Balanced Mutual Fund – The amount of capital gain will be taxed at the rate of 15%.

Capital Gains Tax on Debt Mutual Fund

Category of TaxRate of Tax
ResidentNon-Resident (NRI)
Long Term Capital Gain20% (with indexation)Listed – 20% (with indexation)

Unlisted – 10% (without indexation)

Short Term Capital GainBased on the Investors Tax SlabBased on the Investors Tax Slab

Suppose an investor has an investment in a debt mutual fund. Let us examine the mutual fund taxation associated with various scenarios.

Scenario 1

Long Term Capital Gain on a debt mutual fund whose corpus is invested only in listed debt instruments – The investor puts in Rs. 10,000/- and redeems/sells it for Rs. 12,000/-, the capital gain would be Rs. 2,000/-. The long-term capital gain will be taxed at the rate of 20% after allowing indexation.

Scenario 2

Long Term Capital Gain on a debt mutual fund whose corpus is invested in listed as well as unlisted debt instruments – The investor puts in Rs. 10,000/- and redeems/sells it for Rs. 12,000/-, the capital gain would be Rs. 2,000/-. If the investor were a resident of India, the long-term capital gain would be taxed at the rate of 20% after allowing indexation. If the investor were a non-resident of India, the long-term capital gain will be taxed at the rate of 10% without allowing indexation.

Scenario 3

Short Term Capital Gain on a debt mutual fund – The investor puts in Rs. 10,000/- and redeems/sells it for Rs. 12,000/-, the capital gain would be Rs. 2,000. The short-term capital gain will be taxed based on the tax slab of the investor.

Notes:
i. A tax has to be paid only on capital gain; tax treatment of capital loss will depend on the overall income and loss of the investor under the Income Tax Act.

ii. Indexation is the increase in purchase cost allowed by the Income Tax Act to factor in inflation. The formulae take into consideration the year of purchase and sale of the capital asset.

iii. Surcharge at the rate of 0%, 10% or 15% will be applicable to the capital gain tax amount based on the investor’s tax slab.

iv. Education Cess at the rate of 4% will be applicable on the amount of capital gain tax plus surcharge.

C. Tax Deducted at Source (TDS) Rates for Mutual Funds

Tax Deducted at Source (TDS) is applicable to redemption/sale of mutual funds.

The Fund House while paying the redemption/sale amount to the investor deducts this. The tax credit of this TDS is available to the investor just like any other TDS.

The chart below summarizes the TDS rates on redemption/sale of mutual funds.

Type of Mutual FundResidentNon-Resident (NRI)
Short Term Capital GainLong Term Capital Gain
Equity Fund0%15%10%
Any other Fund0%30%Listed – 20% (with indexation)

Unlisted – 10% (without indexation)

Benefits of Mutual Fund Taxation

While investing in mutual funds, an investor can take tax benefit two times, i.e. at the time of investing and then at the time of redemption/sale. Let us look at how.

a. Tax Benefit While Investing in Mutual Funds

Equity Linked Savings Scheme (ELSS) are open-ended Equity Mutual Funds. When an investor puts in any amount in such funds, the investment qualifies for deduction under section 80C of the Income Tax Act. As such, if the investor puts in Rs. 1,50,000/- (maximum allowed deduction under section 80C), the investor can avail tax savings of up to Rs. 46,800/-.

b. Tax Benefit While Redemption/Sale

Redemption/sale of mutual funds is taxed from rates as low as 0% (long-term capital gain on equity or hybrid or balanced fund of less than Rs. 1 lakh in a year) up to 30% (highest tax slab on short-term capital gain on debt fund).

Conclusion

Mutual Funds are known to outperform fixed deposits, provident fund, and money back life insurance schemes as far as the return on investment is concerned. Add to this the fact that capital gains on equity funds and hybrid/balanced funds are taxed at a minimum of 0% to not more than 15%, mutual funds are a great way to save taxes while investing and redemption/sale. This is especially true for people falling under 20% and 30% tax slabs.

Deepesh Khatri
Deepesh Khatri
deepesh.n.khatri@gmail.com

Deepesh Khatri is a Practicing Chartered Accountant based in Pune. He specializes in Direct as well as Indirect Tax Matters. In his free time, he likes to read and play football.

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