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In India, It's All About Mutual Fund Taxation

In India, It's All About Mutual Fund Taxation

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In India, it's all about Mutual Fund Taxation

All SEBI-registered mutual funds’ income and earnings are tax-free under section 10(23D) of the Income Tax Act. The mutual fund’s returns are taxed in the hands of the investors because the returns are passed through them. A mutual fund distributes its returns to investors in the form of periodic dividends and unit appreciation (increase).

The investor's tax liability is determined by the following factors

  • Residential Status (Indian resident or non-Indian resident (NRI))
  • Mutual fund scheme type (Equity-oriented scheme or a Non-Equity Oriented scheme)
  • Holding Time (Duration of your investment)
  • Residential status: The capital gains tax rates are determined by an investor’s residential status. A person’s residential status can be either “Resident Indian” or “Non-Resident India” (NRI).
  • Fund type: An investor can choose between two types of schemes: equity-oriented schemes and non-equity-oriented schemes.
  • Equity-oriented schemes are mutual funds that invest at least 65 percent of their fund corpus in equity and equity-related instruments. Large cap, mid-cap, balanced funds (equity oriented), sector funds, and so on are examples.
  • Non-equity schemes / Debt funds are mutual funds that invest less than 65 percent of their portfolio in equities and equity-related instruments. Liquid mutual funds, money market funds, gold funds, infrastructure debt funds, balanced funds (debt oriented), and so on are examples.
  • The holding period is the length of time that an investor keeps his investment. The capital gains tax is calculated based on the length of the holding period. The difference between the sale price and the investment’s acquisition cost is referred to as capital gain. Because mutual funds are tax-exempt, the schemes do not pay taxes on the capital gains they generate. Mutual fund investors, on the other hand, must pay capital gains tax.

CAPITAL GAINS TAX

In addition to the investment’s holding period, capital gains tax is based on the type of scheme the investor has chosen to invest in.

(I) Equity-based schemes
Capital Gains on Long-Term Holdings: Nil: on LTCG or Long Term Capital Gains (i.e. if an investment was held for more than a year) arising from STT-paid transactions. This applies to all types of investors, including residents, domestic corporations, and non-resident individuals.

Short Term Capital Gains: 15% of the capital gain plus surcharge as applicable plus education cess @3% on STCG or Short Term Capital Gains (i.e. if investment was held for 1 year or less) arising out of transactions where STT was paid for all categories of investors, namely resident investors, domestic companies, and NRIs. Individual/HUF unit holders who earn more than Rs. 1 crore are subject to a 15% surcharge.

According to the Finance Act of 2017, a 10% surcharge will be levied on individual/HUF unitholders whose income  exceeds Rs. 50 lakhs but does not exceed Rs. 1 crore. 
Furthermore, a 3% education cess will continue to be levied on the total of tax and surcharge.
Where STT is not paid, capital gains from equity products are taxed similarly to debt-oriented schemes
 
ii) Debt-based schemes
Short Term Capital Gains (STCG): A capital gain is considered Short Term Capital Gains (STCG) if it is held for three  years or less. 
It is added to the investor’s income and taxed according to the investor’s tax bracket.
Long-Term Capital Gains (LTCG): If you hold an investment for more than three years, the capital gain is considered Long  Term Capital Gain (LTCG). 
The investor is entitled to the benefit of indexation on LTCG, and capital gains after indexation are taxed at 20% plus  applicable surcharges and a 3% cess.

Indexation is the process of adjusting the cost of acquisition to account for an increase in the value of an asset due to inflation. The Central Government has issued a cost inflation index for this purpose. Long-term capital gains are the only ones who benefit from indexation.

The indexed cost of acquisition is calculated using the following formula:

Indexed cost of acquisition = 

(cost of acquisition of debt-oriented mutual fund units x cost inflation index of the year the debt-oriented mutual fund units are sold)/ (Cost inflation index of the year, the units of the debt-oriented mutual fund were purchased)

The indexation benefit is only available for long-term capital gains, not for short-term capital gains.
After indexation, long-term capital gains are subject to a 20% tax plus a surcharge and an education cess.
For example, suppose an investor purchased units of a debt-oriented mutual fund scheme at Rs 10 and sold them at Rs 15 after three years. 
Assume the government’s inflation index was 400 in the year the units were purchased and 440 in the year the  units were sold. 
The investor would have to pay indexation tax.
The indexed acquisition cost is Rs 10 X 440 400, or Rs 11. 
The post-indexation capital gains are Rs 15 minus Rs 11, i.e. Rs 4 per unit. 
A 20% tax on this would equate to Rs 0.80 per unit. 
Surcharges and education levies are not included. 
Individual/HUF unit holders are subject to a 15% surcharge if their income exceeds Rs. 1 crore. 
According to the Finance Act of 2017, a 10% surcharge will be levied on individual/HUF unitholders whose income  exceeds Rs. 50 lakhs but does not exceed Rs. 1 crore. 
Furthermore, a 3% education cess will continue to be levied on the total of tax and surcharge. 
For NRI investors only, tax is deducted at the source.
 

Capital Gains Tax Rates on Mutual Fund Investment by NRIs for Fiscal Year 2017-18 (Assessment Year 2018-19) are as follows:

1.Equity-based schemes
On equity-oriented schemes, the STCG tax rate is 15%.
The long-term capital gains (LTCG) tax rate on equity funds is NIL.
2.Non-equity investment schemes/debt funds
The STCG tax rate on non-equity schemes or debt funds is determined by the investor’s income tax bracket. 
(Tax Deducted at Source – TDS @ 30% applicable)
The LTCG tax rate on non-equity funds is 20% with indexation on listed mutual fund units and 10% without indexation on unlisted funds.

The Tax Implications of Unitholder Dividends

1.Equity Mutual Fund Dividends
The dividend received by a unit holder from an equity mutual fund is tax-free.
The mutual fund company also receives a tax-free dividend.

2.Debt Fund Dividends
A debt fund unitholder’s dividend income is also tax-free.
However, before distributing this dividend income to Unitholders, the mutual fund company must pay a dividend distribution tax (DDT). Debt Mutual Funds have a DDT of 28.84 percent.

Tax Deducted at Source (TDS)

There is no TDS on dividend distributions or repurchase proceeds for resident individuals. 
However, there is TDS for NRIs, as shown below.

Securities Transaction Tax (STT) What exactly is the Securities Transaction Tax (STT)?

STT is a tax levied on the purchase or sale of securities (other than commodities and currency) listed on Indian stock exchanges. 
This includes stocks, derivatives, and equity-oriented mutual fund units. 
The rate of tax deducted is set by the central government and varies depending on the type of transaction and security. 
STT is deducted at the time of the transaction by the broker or Asset Management Company (AMC).

Dividend Stripping

Dividend stripping is a tax-cutting strategy in which an investor receives a tax-free dividend by investing in securities (including mutual fund units) shortly before the record date (a date fixed by  a company or mutual fund for the purposes of the holders of the securities’ entitlement to  receive dividends or income) and exiting after the record date at a lower price, incurring a loss. 
The tax-free dividend compensates for this short-term capital loss. 
Furthermore, such loss can be set off against capital gains – both short-term and long-term – and the unabsorbed loss can be carried forward for set off in future years.
In layman’s terms, the benefits of dividend stripping are that, on one hand, the investor receives a tax-free/exempt dividend or income and, on the other hand, he suffers a short-term capital loss, i.e. the difference between the NAV and ex-NAV, which can be used or carried forward by the taxpayer to reduce his current or future tax liability.
To discourage dividend stripping, the tax department issued new rules under section 94(7) in 2004 that stated:
The loss incurred as a result of the sale of units in the schemes (where the dividend is tax-free) will not be set off to the extent of the tax-free dividend declared; if units are:
(A) Purchased within three months of the record date for dividend declaration and
(B) Sold within nine months of the dividend declaration record date.
All of the conditions listed above must be met in order for section 94(7) to be applicable; if any of the conditions is not met, this section will be inapplicable.
On June 30, 2017, Mr. X purchases 100 units of ABC mutual fund at a price of Rs.10 per unit. The record date for declaring the dividend is August 15, 2017 for a dividend of Rs.2 per unit. The dividend paid on mutual funds is tax-free. Mr. X then sells all of the units on November 30, 2017 for Rs.7 per unit.
Mutual Fund Company Dividend: Rs 200
The following payment was made for the purchase of units: Rs 1000.
Capital loss on unit sale: (10-7) x 100 = 300
So, instead of setting off the entire capital loss of Rs.300, Mr. X will be allowed to set off the loss after deducting the amount of dividend earned from those units, i.e. 300-200=100.
Mr. X will be permitted to set off only Rs.100.

Bonus Stripping

According to Section 94(8) of the Act, the loss resulting from the sale of original units in schemes where bonus units are issued will not be set off; if original units are:

(A) Purchased within three months of the record date for bonus unit allotment; and

(B) Sold within nine months of the record date for bonus unit allotment. The amount of loss that is ignored, however, is deemed to be the cost of purchasing or acquiring such unsold bonus units.

Assume an investor purchases 1000 units of a scheme at Rs10 each, for a total of Rs10000 on June 10, 2017. 
Following that, on June 14, 2017, the scheme declares a 1:1 bonus issue, which means that the investor receives one new unit for every unit purchased previously. 
The investor would now own 2000 units for Rs.10000. 
At this point, what is the tax treatment if the investor sells the original unit for Rs 8 on August 31, 2017?
The unit price is 1000 multiplied by 8 to equal 8000.
 
Unit cost = 1000*10 = 10000
 
Units lost = 2000 (10000-8000)
 
The loss of Rs.2000 will now be ignored under section 94(8). 
And the Rs.2000 loss will be the cost of the 1000 bonus units.
 
Please keep in mind that this section only applies to mutual fund units, not shares.

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