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Article | Sip - Feb 09, 2017 | 13:36 PM

How mutual funds returns are taxed

Birla Sunlife - Grow My Money - How mutual funds returns are taxed

As a popular adage goes, there are two things certain in life; death and taxes. And yet, most of us are either ignorant of our tax liabilities or are trying to save taxes by numerous ways and mechanisms. Investing in mutual funds is supposed to be one of the ways to save tax. While, there is truth to it (like for instance by investing in ELSS schemes), largely there is a tax liability to take care of as well.

So, to cut the long story short, here is what you should know about taxes and mutual funds, especially capital gains tax. Know all about it and stay invested:

Capital gains

Capital gains in mutual funds is simply the difference between the market value of the fund unit at the time of redemption and purchase. In other words, it is the profit the investor makes when they sell their mutual fund units. There are two types of capital gains i.e long-term capital gains (LTCG) and short-term capital gains (STCG). As the name suggests, the category is bifurcated depending on the term period. However, the term period can differ based on the type of fund. The tax applied on these capital gains is known as capital gains tax.

Tax on equity mutual funds

Taxation on equity mutual funds or equity oriented schemes is fairly simple. To qualify as an equity oriented scheme, the portfolio must contain 65% or more of its holdings in domestic equity shares. Even ELSS funds would be classified as equity with the difference being that you get Section 80C deduction for it.

Any capital gain for a unit held for longer than 12 months is considered as a long-term capital gain. There is no tax on long-term capital gains.

A short-term holding (12 months or less) has a flat tax rate of 15% on the capital gains, whether you are a domestic investor or an NRI.

Similarly, any dividends or distributed income from equity funds are exempt from, irrespective of when you receive it.

Tax on non-equity mutual funds

Non-equity mutual funds include debt funds, liquid funds, money market funds and infrastructure debt funds.

For non-equity mutual funds, units need to held for more than 36 months to be classified as long term. Long-term capital gains are taxed at 20% with indexation. Basically, indexation can be defined as adjusting the price of a particular value for inflation. And then, inflation is calculated every financial year, and the value is called the Cost Inflation Index (CII). The primary idea is to factor in the rise of prices so that investor has to pay tax only on the “real gains”.

For example, let's say an investor has made an initial investment of Rs 50,000 in a debt fund and has held units for more than three years. For the sake of simplicity, the investor has got a return of 10% p.a. The returns could be Rs 66550.

Now the value of CII for the FY2016-2017 is 1125 and for the FY 2014-2015 is 1024 which would be the base year value.

To calculate capital gains (CG) with indexation, the steps are as follows:

CG= Returns- [Initial investment*{CII current year/CII base year}]

     = 66550-[50000* {1125/1024}]

     = 66550-[50000*1.098]

     = 66550- 54900

     = 11650

Tax with indexation= 11650*20%= 2330

Therefore, considering the profit is Rs 16550 (66,550-50,000) the effective tax the investor needs to pay is just 14% (2330/16550).

Also, capital gains realised on debt fund units held for less than 36 months would be categorised as short-term capital gains. It is perhaps the only scenario where the investor would be taxed according to their respective tax slabs. Capital gains will be added as part of the income and if the investors falls in the 10% tax bracket, the tax rate on CG will be 10%. Similarly, if the investor falls under the 30% tax bracket, any STCG will be taxed at 30%. Any domestic company, however, will be taxed at a flat 30% for STCG on non-equity schemes.

While dividends in debt oriented schemes are nil, there is a catch known as the dividend distribution tax (DDT). As per the Union Budget of 2016, there is a dividend distribution tax (DDT) for retail investors at 28.33% including surcharge and cess. It can be broken up as

 25%+ (12% *0.25)+ 3% *(0.25+ 12% *0.25)

= 28.84

However, the investor does not pay this tax, at least not directly. The fund house deducts it from the NAV of the scheme to the extent of statutory levy (if applicable) and pursuant to the payout of the dividend the NAV of the scheme would fall to the extent of payout and statutory(if applicable) .

Investors need to be careful while considering debt funds especially the dividend option. Also, any systematic transfer plans would also count as a redemption and might be subject to taxation depending on the fund.

Happy investing!


Disclaimer: Mutual Fund investments are subject to market risks, read all scheme related documents carefully

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