How does taxation work in Mutual Funds?

The mutual fund industry in India has grown leaps and bounds in the last few years and each year the assets under management are increasing at a phenomenal pace. The growth in the mutual fund industry is essentially from retail investors and a significant portion of household savings is now being invested through mutual funds. Just like all other investments apart from returns, it is equally important to understand the tax implications of an investment.

Primarily, the income for all types of mutual fund investments is either in the form of capital gain income (gains realised at the time of selling your investment) or dividend income which is received at regular intervals in case of dividend schemes.  Capital gains are further divided into short-term capital gains and long-term capital gains depending upon the holding period of the investment.

The taxation the various types of mutual fund schemes are taxed either as equity mutual funds or debt mutual funds depending upon the portfolio holding.

Taxation on Equity Mutual Fund Schemes

  • In any mutual fund scheme, if more than 65% of the corpus is invested in equities, then such schemes are treated as equity schemes from the perspective of taxation.
  • If investments from equity schemes are redeemed before completion of 12 months then the gains arising from the same are treated as short-term capital gains and short term capital gains tax is applicable at 15%.
  • If the investments in equity schemes are redeemed after completion of 12 months then gains arising from the sale of investment are taxed as long term capital gains tax at 10%. However, capital gains over and above 1 lakh are will be taxed. So, if your capital gains from equity investments are below 1 lakh, then such gains are exempt from tax.
  • Moreover, all gains from equity mutual funds and shares before 31st January 2018, will be grandfathered and only gains made after 31st January will be taxed.
  • Dividend income received from equity mutual funds is tax-free in the hands of the investor as these dividends are distributed after the mutual funds already pay a dividend distribution tax (DDT) of 11.648%. However, dividend received in excess of Rs. 10 lakh will be charged at 10%.
  • Arbitrage mutual funds are treated as equity funds for the purpose of taxation.
  • Equity-linked savings scheme or ELSS are a special type of equity funds. Investments made in such schemes are exempt up to Rs 1.5 lakh under section 80C and the income arising from investments in ELSS is exempt from tax. However, there is a lock-in period of 3 years in such schemes.
  • An investor can offset the short-term capital loss against short-term capital gains or long-term capital gains. You can set –off long-term capital losses against long-term capital gains only.

Taxation on Debt Funds

  • Mutual fund schemes in which the proportion of equity investment is less than 65% are considered to be debt schemes.
  • In case of such funds if you sell your investments before 36 months then any gains arising from such sale is termed as short-term capital gains and it is added to your income and taxed as per your income tax slab.
  • If you sell your investments after completion of three years, then the returns are considered as long-term capital gains and taxed at 20% with indexation benefit. Indexation benefit means adjusting gains after taking inflation into account.
  • Dividend income arising from debt funds through tax-free in the hands of investor is paid out after deducting dividend distribution tax of 29.12%.
  • International funds and fund of funds are also considered as debt funds for the purpose of taxation and taxed as per debt funds.

In the case of debt funds too, short-term capital loss can be offset against short-term capital gains or long-term capital gains. The long-term capital loss can be offset only against long-term capital gains. Moreover, in both cases, capital loss cannot be adjusted against any other head of income.

Summing up:

Thus, mutual funds are taxed according to their equity holding. Debt funds are considered better in post-tax yield as compared to other debt investment opportunities because it has the benefit of indexation of investments longer than 3 years. This facility is not available to its counterparts like bank fixed deposit, recurring deposit, etc.

On the other hand, equity mutual funds were considered to give tax-free returns for a tenure longer than one year, which has changed from this financial year. They are taxed but only the capital gain portion which is more than Rs 1 lakh p.a. So, for people in the higher tax bracket, this is still quite an attractive proposition! Overall mutual funds are quite taxed efficient and are quite a good product to buy.