Mutual Funds and Taxes - A Primer

Taxation of mutual fund income is a very important component in the investment process because taxes can eat away a part of the returns that have been generated by the fund. This reduces the effective returns earned by the investor. Naturally, zero tax or lower tax increase the attractiveness of any investment. Awareness of the applicable tax rules is a pre-requisite when you are recommending investments or drawing up plans for your clients. Here is a look at the various aspects of taxation of mutual fund investments.

Nature of fund

Before looking at the exact manner of taxation of the income there is a distinction that has to be made about the nature of a mutual fund scheme. This distinction is between an equity fund and a debt fund has important implications because the nature of taxation is different for both these type of funds. A mutual fund scheme with an average allocation of 65 per cent of the assets under management into equities of domestic companies during the year is classified as an equity oriented fund. Any scheme that does not meet this definition would be classified as a debt oriented fund. There are certain income tax benefits for equity oriented funds so there is an effort by the mutual funds sometimes to stretch the equity component so that more schemes can be classified as equity schemes. One of the best examples here is that of balanced funds which have between 70-75 per cent of their corpus in equities so that they can be classified as equity oriented funds. The name balanced fund might suggest an equal allocation to debt and equity but in reality the situation is a bit different. 

Dividend

One of the ways in which the return from a mutual fund scheme is paid out is by declaring dividends. This is received by investors who have opted for the dividend option in the scheme. The tax impact of dividend for both resident and non resident individuals is the same. Dividends received by investors are tax free in their hands. Thus any receipt that comes to them in the form of dividend either from an equity fund or a debt fund will not be considered as income for the purpose of taxation. This constitutes the direct impact of the dividend in a mutual fund scheme.

There is also an indirect expense when it comes to the issue of dividend because there is a Dividend Distribution Tax (DDT) that is applicable for debt oriented funds. This is a tax that has to be paid by the mutual fund when the dividend is declared but since it is adjusted in the Net Asset Value (NAV) of the fund this becomes an indirect cost for the investor even though they do not pay the tax.

There is no DDT for an equity oriented fund but there is DDT for debt funds. The rate of DDT for debt fund varies according to the nature of the scheme as well as the type of investor receiving the payment. For liquid and money market funds the DDT rate is 25 per cent (plus surcharge and cess) and this rate is applicable for all investors. For debt funds other than liquid or money market funds the rate is 12.5 per cent (plus surcharge and cess) for individuals and Hindu Undivided Families and 20 per cent (plus surcharge and cess) for all other type of investors.

Capital gains

The other form in which income is earned on mutual funds is capital gains.  Capital gains or losses are earned as there is a difference between the price at which the mutual fund is bought and the price at which this is sold. In case the holding period of the mutual fund is for more than 12 months then the gains or loss will be known as a long term capital gain or loss and if the holding period is 12 months or less the gain or loss will be short term in nature.

A long term capital gain earned on an equity oriented fund will be tax free. This means that there is no tax to be paid on such an investment. On the other hand the short term capital gain on an equity oriented fund will be taxed at 15 per cent.

The situation is slightly different for a debt oriented fund. The short term capital gain in a debt oriented fund will be added to the income of the investor so this will be taxed at the highest rate at which the total income is getting taxed. On the other hand if there is a long term gain on debt oriented funds then this will be taxed either at 20 per cent with the benefit of indexation or 10 per cent without the benefit of indexation whichever is lower.

Non residents will have the same tax impact as residents with the exception that there will be a tax deduction at source on the gains when there is a short or long term capital gain on debt oriented funds and short term capital gains on equity oriented funds.

If there is long term capital loss in an equity oriented fund then it cannot be set off against any income. A long term capital loss in a debt oriented fund can be set off only against a long term capital gain. A short term capital loss can be set off either against a short term capital gain or a long term capital gain.

Taxes at a glance

Dividend Distribution Tax rate

*plus applicable surcharge and education cess