All You Need to Know About Taxation of Mutual Funds

As more and more banks provide lower rates of return on FDs and savings accounts, mutual funds emerged as a preferred investment route for investors from various walks of life. In fact, the reach of mutual funds in India has now moved beyond just the larger cities and has now moved on to even the country’s smaller urban locations. With mutual fund investment inflows recorded at an all time high of Rs. 2 lakh crore during April to September 2017, investors large and small are investing their hard earned money into mutual funds.

It hence is only natural that more and more investors are asking questions regarding the tax implications of their investments. In the following sections, we will discuss the current mutual fund tax rules.

Equity Mutual Fund Tax Rules

Equity mutual funds by definition invest a major portion of their capital assets in domestic equities, while the remainder is invested in various debt and money market schemes. Equity mutual fund returns are not subject to wealth tax unlike gold and property however, they are subject to short and long term capital gains taxation rules. Currently, if an equity fund investment is held for less than 1 year from the date of unit allotment prior to being redeemed for a profit, the returns are subject to short term capital gains (STCG). Similarly, in case the equity fund units have been held for over 1 year before booking a profit through switch or redemption, the returns are subject to long term capital gains (LTCG). At present the taxation rate for STCG on equity funds is 15% of profits, while LTCG is completely tax free for equity fund investors. Thus all you need to do to get tax free returns from your equity investments such as large cap, midcap, small cap or index funds is to ensure that you are staying invested for over 1 year from the date of unit allotment before redeeming or switching.

Taxation of ELSS

ELSS or equity linked savings scheme are among the most popular equity investments out there and their taxation rules are unique even though they are a part of the larger equity funds group. For starters they are EEE investments under Section 80 C of the Income Tax Act, 1961 i.e. the principal invested, the returns generated as well as the maturity amount are all tax free. Moreover, these investments have a lock-in of 3 years during which ELSS Funds units cannot be redeemed or switched. Hence the equity mutual fund tax rules with respect to STCG are not applicable to ELSS and all returns after lock-in are completely tax free under Section 80C.

Taxation of Debt Mutual Fund Schemes

Debt mutual funds by definition allocate a major portion of their capital towards various debt as well as money market instruments with the provision of minor allocation towards equities. Similar to equity mutual funds, debt funds too are subject to short and long term gains, however, the definitions of short and long term are different for debt investment. In case of debt funds, STCG is applicable to investments that are redeemed for a profit prior to completion of 3 years from the date of unit allotment, while debt investments held for more than 3 years are subject to LTCG. The current STCG on debt funds is as per the applicable tax slab rate of the investor as part of the income from other sources head. As per FY 2017-18 (AY 2018-19) tax slabs, if your taxable income is less than Rs. 2.5 lakhs, your debt fund STCG is zero. Similarly, applicable tax rate will be 5% of total debt fund gains in case taxable income is greater than Rs. 2.5 lakhs and less than Rs. 5 lakhs. Higher rates of 20% and above are applicable to those with higher taxable income. LTCG on debt mutual funds feature a tax rate of 20% on your gains if you have received indexation benefit while the applicable rate is 10% in case indexation benefit is not availed.

International Mutual Fund Tax Rules

International mutual funds are schemes that invest almost exclusively in international equities of various companies. These funds are not classified as equity funds as they do not primarily invest in domestic equities. Hence, Indian mutual funds primarily engaged in making overseas equity investments are taxed as per the STCG and LTCG rules of debt mutual funds. The same taxation mechanism also holds true for Indian fund of funds that invest in international mutual funds.

Taxation of Hybrid Mutual Fund Schemes

By definition, hybrid mutual fund schemes have the allowance of investing in equity stock and equity-based instruments as well as debt and money market instruments. From a taxation perspective, the allocation of the hybrid fund’s assets is what’s important. If the hybrid fund invests mainly in equities, it is termed as an equity-oriented savings scheme. On the other hand, if the major investment of a hybrid fund is towards debt and money market schemes, the fund is determined to be a debt-oriented hybrid fund. A hybrid fund designated as equity oriented scheme, such as an arbitrage fund, is taxed as per the STCG and LTCG rules of equity investments. Similarly a debt-oriented hybrid scheme such as a monthly income plan is taxable as per the taxation rules of debt investments.

Taxation of Mutual Fund Dividends

Earlier, if you would have invested in the dividend option of a mutual fund and received dividends from the scheme, those payouts were tax free for you as per the taxation rules. However, after the Budget 2020, there is a major change in the taxation policy on the dividend income earned by the investors. Dividends, which were earlier taxed at the source by the distributing company, will now be taxed at the hands of the investors according to their income tax slab. In the new tax regime, Dividend Income will be included in the taxable income of the investor as ‘income from other sources’.

Conclusion

In the above sections we have covered the general taxation rules of some key types of mutual funds currently available in India. However exact details of which mutual fund tax rules will apply to a specific fund will of course depend on the composition of the fund itself and can be found in key fund documents such as SID and KIM. Thus do make sure that you are aware of the applicable taxation rules of your prospective investment before investing in order to avoid any unwelcome surprises later on.

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