Mutual Fund Taxation For Individuals Made Simple

Even geniuses find tax codes hard to comprehend! Albert Einstein once said that the hardest thing to understand in the world is income tax. If you’re a Mutual Fund investor, and find yourself baffled with the calculations of just how much tax you need to pay on your investments, read this.

Equity or non-equity – the first question
The tax treatment for returns arising from equity oriented funds differs from returns arising from non-equity oriented funds. The first question to ask yourself is would therefore be, is your fund equity oriented or not? Any mutual fund that holds over 65% of its portfolio in stocks is treated as an equity fund from the taxation standpoint. Any fund that holds less than 65% of its portfolio in Indian stocks is treated as a non-equity oriented fund from the taxation standpoint. The former category includes all diversified, large cap, mid cap, sectoral and thematic funds, as well as arbitrage funds and some aggressive balanced funds.

Do note that returns from International Equity Funds are taxed as “Non-Equity”, in spite of the fact that they invest into stocks. “The funds which invest in international equities or in any foreign mutual fund enjoy the same tax efficiency of a non-equity fund. Capital gains upto 3 years is considered as short term capital gains and taxed at the marginal rate of taxation of an investor and any capital gain beyond 3 years is long term capital gains and will attract a tax of 20% with indexation benefits”, advises R. Raja, Head Products, UTI AMC.

Dividend of capital gain – the second question
Having established whether your fund is equity oriented or not, you now need to ask yourself the second question – are the profits arising from a dividend, or have the profits been booked by you deliberately (via a sale of units, a systematic transfer, or a systematic withdrawal)?

Dividends arising from equity funds are tax free, whereas dividends arising from debt funds are taxed at 28.84% before distributing it to you. Once received in your account, no further taxes are payable on dividends received.

Do note here that profits earned by you form your Mutual Fund may comprise of a mix of dividends and capital gains. For instance, you may have invested Rs. 100,000 in a scheme, received dividends of Rs. 10,000 in the year, and redeemed Rs. 105,000. In this illustration, your dividend is Rs. 10,000 and your capital gains are Rs. 5,000.

Capital gains? Long or short term – the third question
If you’ve booked capital gains from your Mutual Fund investments, you need to ask yourself the third question – are they long term or short term capital gains? For Equity Oriented funds, profits booked on units held for less than 1 year are counted as short term capital gains; for non-equity oriented funds, this period is 3 years.

Short Term capital gains arising from Equity Oriented funds are taxed at 15%. For instance, if you’ve invested Rs. 100,000 in an equity fund and redeemed Rs. 110,000 in 10 months, you’ll need to pay a tax of Rs. 1,500. Long Term capital gains from equity funds are tax exempt.

Short Term capital gains arising from non-Equity oriented funds are clubbed with your income for the same year in which you’ve sold the units, and are therefore subject to the highest tax bracket that your income for that year is subject to (“taxed at the margin”) . Long term capital gains are taxed at 20% of the indexed profits, that is, the profit earned after adjusting the purchase cost with the “change in inflation during the years that you’ve held on to the investment” (using Cost Inflation Index as the indicator).

Raja of UTI AMC suggests that investing into hybrid multi asset funds such as Equity Oriented Balanced Funds could help investors maximize tax efficiency. “Asset allocation Plans or balanced schemes which invest in multi-assets but are equity oriented also could maximize tax efficiency as the investor gets tax benefits of equity funds in such funds though the fund invests in multiple assets”, he advises.

Each tranche is a new purchase
If you’re a monthly investor, remember that each SIP installment is treated as a fresh purchase, and will therefore have a different date on which it migrates from attracting short term to long term capital gains tax. Similarly, if you’re making a systematic transfer from a liquid fund to an equity fund via an STP, each outflow is actually a sale of liquid fund units and each inflow is a purchase of equity fund units.

A final word on tax efficiency
As a collective group, we Indians tend to attach excessive significance to tax efficiency. In reality, tax efficiency should be a secondary consideration to having a well balanced portfolio that is in line with your risk appetite, and to following a smart profit booking strategy. If the index runs up to insane levels and a serious correction is in the offing, for instance, you may not want to wait out an additional few months to save on taxes. That would be akin to missing the woods for the trees.

Raja of UTI AMC agrees that tax efficiency should be a secondary consideration to the optimal asset allocation leading up to the achievement of Financial Goals. “When you invest in any tax planning instrument, the asset class to which it belongs, the proportion of the said asset class in your portfolio and your risk-return profile has to be kept in mind, in addition to tax savings. Tax savings act as a kicker or accelerator to reach your financial destination” he says in conclusion.