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Feb 24, 2012,09.10 IST

How you can benefit from Mutual Fund tax rules?

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PersonalFN

At PersonalFN, we frequently come across clients who fit the following profile:

Age: Mid 30s to mid 40s

Monthly Income: Rs. 1 lakh per month and above

Field: Business / IT / Medicine / BFSI / Telecom / HR / Pharma / Import - Export etc

These individuals are doing well in their careers, are settled down with family and kids, and are savvy not just about their own fields but also have general awareness about personal finance.

They understand the need to plan for their life goals, to invest regularly to build a recommended mutual fund portfolio, and to save tax. They will follow recommendations, invest on time, not panic when the market falls but increase their investments and generally display a good level of financial know-how � the kind of behavior that will help them become truly wealthy by the time they retire.

And yet, the one thing they invariably ask about is taxation, particularly mutual fund taxation.

Maybe this is because taxation by itself is a boring matter. It can be slightly confusing and can often feel tedious. But did you know you can use mutual fund tax rules to your advantage?

We�ve come up with a very simple quick and easy guide to mutual fund taxation in a quick FAQ format. We�ll cover the different taxes on mutual funds i.e. on capital gains and on dividends for equity and debt funds and gold ETFs, including taxation for NRIs and finish off with a simple example that will help you understand indexation.

Let�s get started.

1. What is Capital Gain?

Capital Gain is nothing but gain on your capital i.e. an appreciation in the value of the asset at the time of sale. Similarly, Capital Loss is a loss in the value of the asset at the time of sale. For example, if you buy an asset for Rs. 5 lakhs and sell it for Rs. 6 lakhs, you have made a Rs. 1 lakh capital gain. If on the other hand you have sold it for Rs. 4 lakhs, you have made a Rs. 1 lakh capital loss. For the purposes of this article we will deal with capital gain, to see taxation.

2. What are Short Term and Long Term Capital Gain?

Short Term Capital Gain arises when an asset is held for less than a certain period and then sold. Long Term Capital Gain arises when it is sold post its short term period.

In most cases, this period is 1 year however for some assets it is longer.
For example, shares, equity and debt mutual funds and gold funds (including gold ETFs) are classified as short term assets if they are held for less than 1 year (i.e. less than 365 days). Long term is more than 365 days.

Physical gold on the other hand, and also real estate, is considered short term is if it held for less than 3 years and sold. Long term is 3 years or more.

3. What is Short Term Capital Gain (STCG) on Equity Mutual Funds?

STCG on Equity Mutual Funds is 15%.

This means that if you invest in an equity mutual fund today and redeem your investment before February 13th, 2013, you will pay 15% on any gains you have made.

4. What is Long Term Capital Gain (LTCG) on Equity Mutual Funds?

If an equity mutual fund is held for 1 year or more and then sold, there is no tax to be paid on it. In other words, LTCG on equity mutual funds is NIL.

5. How does NRI taxation differ from equity fund taxation for resident investors?

If you are an NRI and you invest in an equity mutual fund and redeem it within one year, tax will be deducted at source i.e. TDS will apply at 15%. This is only for NRIs, not for resident individual investors. There is no TDS on LTCG on equity schemes, as there is no LTCG tax on these schemes.

6. What is STCG on non-equity mutual funds?

A non-equity scheme is one which holds less than 65% of its exposure to equity. For a scheme to be classified as equity and avail the tax benefits that equity enjoys, it must hold at least 65% equity in its portfolio.

A non equity scheme is taxed as per the individual investor�s tax slab if sold in less than a year.

So if your tax bracket is 30%, and you sell a debt fund within 1 year, you will pay commensurate tax on your gains.

7. What is LTCG on non-equity mutual funds?

Now things become interesting. If you buy a debt mutual fund and hold it for the long term, you can avail the benefit of something called Indexation.
Indexation is a way for you to tie your gains to the cost inflation index (CII), which takes into account the effect of inflation and thereby reduces the value of your gains on paper by increasing the paper value of your purchase amount. This enables you to pay less tax. It's the Government�s way of helping you keep the real value of your money.

If you sell a debt fund after 1 year, you will pay 10% without indexation OR 20% with indexation plus 3% cess.

8. How does NRI taxation differ for debt fund investors?

If you are an NRI and have made LTCG on a debt mutual fund, TDS will be applicable at 20%. This does not apply to resident debt fund investors. TDS on STCG is applicable at 30% for debt mutual fund investments.

9. What is the difference in taxation on money market / liquid funds and other debt funds?

Debt funds can be divided into 2 categories based on taxation

A) Money Market / Liquid Funds,

B) Other debt funds

Money Market / Liquid Funds are taxed the same as debt mutual funds as regards STCG and LTCG. The only difference is with respect to dividends distributed. Where these funds are concerned, dividends are taxed at 25% plus 5% surcharge plus 3% cess, which comes to approximately 27% taxation on dividends, before they are given to you, the investor.

For other debt funds (non liquid / money market schemes), dividends are taxed at 12.5% plus 5% surcharge plus 3% cess which comes to approximately 13.52% tax.

10. How are Gold ETFs and Gold Mutual Funds taxed?

Gold ETFs and gold mutual funds are taxed the same way as debt mutual funds ( i.e. non liquid non money market schemes). Thus, short term gains are taxed as per your tax slab, long term gains are taxed at 10% without indexation or 20% with indexation, and the long term period is 1 year or more.
Wealth tax does not apply to gold fund units and ETF units. It applies to physical gold however.

Here�s a broad summary table of the information covered in the FAQs above.

Type of Mutual Fund Defination of Short term & Long term Short term Cap gain Treatment Long term Cap gain Treatment Dividend Distribution Tax (DDT)
Equity Mutual Funds Less than 365 days is Short Term.  15% taxation NIL NIL
365 days or more is Long Term.
Debt Mutual Funds (non Liquid schemes) Less than 365 days is Short Term.  Taxed as per individual tax slab of the investor 10% without indexation OR 20% with indexation, plus 3% cess 12.5% plus 5% surcharge plus 3% cess, totally 13.519%
365 days or more is Long Term.
Money Market and Liquid Schemes Less than 365 days is Short Term.  Taxed as per individual tax slab of the investor 10% without indexation OR 20% with indexation, plus 3% cess 25% plus 5% surcharge plus 3% cess, totally 27.038%
365 days or more is Long Term.
Gold ETFs Same as Debt Mutual Funds Same as Debt Mutual Funds Same as Debt Mutual Funds Same as Debt Mutual Funds

 

When investing in a particular mutual fund, the first thing you need to do to assess its returns is know how it will be taxed. It is the post tax returns that will matter.

Let�s look at a Fixed Maturity Plan for example.

Mr. Shah, our favourite fictional character, invested in a 370 days FMP from ABC fund house.

He invested Rs. 10 lakhs in this fund on Feb 5th, 2010. Being a 370 day FMP, it matured on Feb 10th, 2011. The maturity amount is Rs. 11 lakhs.
Hence, on an investment of Rs. 10 lakhs, he had made Rs. 1 lakh pre tax, i.e. a 10% pre tax profit.

Now, as per debt mutual fund taxation, he has 2 choices: Index, Don�t Index.

If he doesn�t index his gains, he pays flat 10% without indexation, i.e. Rs. 10,000.

His net gain is Rs. 90,000, or 9% post tax. He has lost 1% of his 10% gain to taxes.

If he indexes, the calculation is as follows:

Purchase Price: Rs. 10 lakhs
CII for Year of Purchase (FY 10-11): 711
CII for Year of Sale (FY 11-12): 785
Indexed Purchase Price: Rs. 10,00,000 x (785/711) = Rs. 11,04,078
Gain after Indexation: Rs. 0 (purchase price is higher than sale price)
Tax to be paid @ 20%: Rs. 0

 

 

 

 

 

 

His entire gain becomes effectively post tax gain. This is the beauty of indexation.

So remember, know your mutual fund taxation rules and it will definitely help you save tax and invest more towards your life goals, thus helping you to achieve them faster.

(PersonalFN is a Mumbai-based personal finance website)

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