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As more and more people in India start investing in Mutual Funds, a common question that faces investors is whether the profits are taxable. After all, the returns from many other popular investments like recurring deposits, fixed deposits, Kisan Vikas Patra, etc. are all taxable. Additionally, as there are different types of Mutual Funds – Equity, Debt and Hybrid, is the tax on Mutual Funds same in all cases? Read on to find out how taxation of different types of mutual funds in India works.
Factors Impacting Tax on Mutual Funds in India?
Various factors play a key role in the mutual funds taxation in India. Here we will break down the key factors that can impact the applicable tax on mutual fund returns-
1. The Type of Mutual Fund
Tax on mutual funds is divided into two categories- equity mutual funds and non-equity mutual funds. All equity Mutual funds are taxed based on one rule, while all non-equity mutual funds are taxed based on a different set of rules.
2. Type of Gain
One type of gains on mutual funds that are taxed are generated upon selling fund units at a price higher than the purchase cost. Another type of profit from mutual funds are dividends. Dividend is a part of the profit shared by the fund manager with the investors.
3. Based on Holding Period
Tax on mutual funds also depends upon the holding period of the mutual fund units. A long holding period is typically beneficial for investors as the rate of taxation tends to be lower.
Capital Gains Tax Rules for Equity Mutual Funds
In a mutual fund, if 65% or more of total investments are made in Indian equities or other domestic equity-oriented instruments, the scheme is considered as an equity mutual fund. Returns from equity Mutual Funds are taxed based on Capital Gains taxation rules of equity funds.
Equity mutual fund capital gains from sale of units are classified as short term capital gains (STCG), if units are held for less than 1 year prior to being sold. While if redemption of units occurs after 1 year from date of unit purchase, long-term capital gains (LTCG) rules will be applicable.
1. Long term Capital Gains on Equity Funds
Long Term Capital Gains tax on equity Mutual funds is 10%, if the long-term capital gains for the fiscal year exceed Rs. 1 lakh. As per existing rules of equity mutual fund taxation, long term capital gains up to Rs. 1 lakh in a financial year are not taxable.
2. Short-Term Capital Gains on Equity Funds
Short Term Capital Gains (STCG) on equity mutual funds is applicable if scheme units are sold for a profit within 1 year of being bought. STCG tax rate on equity mutual funds is 15% irrespective of the total short-term gains from equities during the financial year.
Capital Gains Taxation Rules for Debt Mutual Funds
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A debt fund is a type of mutual fund where a majority of assets are allocated to fixed-income investment instruments like bonds, certificate of deposits, treasury bills etc. that are traded in the bond market or money market. As an investor, you will get short-term capital gains when you redeem your debt fund units within 3 years of purchase. Short term capital gains tax on debt mutual funds are as per the income tax slab rate of the investor.
However, if you sell debt fund units after holding it for three years or more, you will receive long term capital gains. Long term capital gains tax rate for debt mutual funds is 20% with indexation.
Applicability of Capital Gains Tax to Hybrid Funds
Taxation of mutual funds categorised as hybrid funds depends upon the scheme’s equity exposure. If equity allocation of hybrid funds exceeds 65%, the hybrid fund will be taxed similarly to the equity funds.
So, long term gains over Rs. 1 lakh in a financial year will be taxed at a 10% rate. Short term gains from equity-oriented hybrid funds will thus be taxed at 15%. Debt-oriented hybrid funds that have equity allocation lower than 65% will be taxed as per debt mutual fund taxation rules. In this case, after indexation, the long term capital gains will be taxable at 20%. In the other hand short term gains from debt-oriented mutual funds will be taxed as per the income tax slab rate of the investor.
Taxation of mutual funds categorised as hybrid funds depends upon the scheme’s equity exposure. If equity allocation of hybrid funds exceeds 65%, the hybrid fund will be taxed similarly to the equity funds.
So, long term gains over Rs. 1 lakh in a financial year will be taxed at a 10% rate. Short term gains from equity-oriented hybrid funds will thus be taxed at 15%. Debt-oriented hybrid funds that have equity allocation lower than 65% will be taxed as per debt mutual fund taxation rules. In this case, after indexation, the long term capital gains will be taxable at 20%. In the other hand short term gains from debt-oriented mutual funds will be taxed as per the income tax slab rate of the investor.
Taxation Rules for ELSS Tax Saver Funds
When it comes to tax on mutual funds in the ELSS category, investments you make in tax saver funds are eligible for tax benefits under Section 80C of the Income Tax Act, 1961. DO remeber that while there is no limit on the investment amount, you can only receive a tax deduction on a maximum amount of INR 1.5 lakh in a financial year. Since ELSS have a lock-in period of 3 years, redemption of units prior to completion of 1 year is not possible. Tax on long-term capital gains from tax saver mutual fund redemption is applicable as per current equity mutual fund taxation rules.
What is the Tax on Dividends offered by Mutual Funds
Dividend can be declared by the IDCW option (earlier known as dividend option) of any type of Mutual Funds. Under existing rules for tax on mutual funds, dividends are completely taxable in the hands of the investor. Dividend pay outs are added to the taxable income of the investor under the head “Income from Other Sources”. This income then is taxed as per the applicable income tax slab rate of the investor. Additionally, tax deducted at source (TDS) at 10% of dividend pay-out is also applicable in these cases.
What is Dividend Distribution Tax for Mutual Funds
As per earlier mutual fund tax rules, it was mandatory for mutual funds to pay Dividend Distribution Tax (DDT) whenever dividends were declared and paid out to investors. Under this rule, any dividend income received by the investor was tax free.
As of April 2020, DDT is no longer applicable to dividends paid out by mutual funds, but dividend income is now completely taxable in the hands of the investor.
Role of Securities Transaction Tax (STT) in Mutual Fund Investments
Securities Transaction Tax (STT) is levied on transactions in securities such as equity mutual fund units done in India. Currently, STT on equity-oriented mutual fund transactions is applicable at the below mentioned rates:
Transaction Type |
STT Rate |
Payable by |
Purchase of units of equity-oriented mutual fund |
Nil |
N/A |
Sale of units of equity mutual fund (delivery based) |
0.001% |
Seller |
Sale of units of equity mutual fund (non-delivery based) |
0.025% |
Seller |
Sale of units of equity fund to the Mutual Fund (redemption) |
0.001% |
Seller |
How are Indexation and Tax on Mutual Funds Related?
When discussing the tax on mutual funds, you should know how indexation and tax on mutual funds are related. Indexation means recalculation of the purchase price after you adjust the returns based on the inflation index.
The indexation is currently applicable only to long-term capital gains tax on debt mutual funds in India. The final asset value upon adjusting for inflation decreases the taxable capital gains which reduces the investor’s tax liability from the investment. So, the indexation will be applied to the long-term capital gains to reduce the tax to get higher returns.
As an investor in debt funds, if you sell any debt fund units after a holding period of 36 months, the profits will fall in the long-term capital gain category and be eligible for the lower tax outgo resulting from indexation.
When discussing the tax on mutual funds, you should know how indexation and tax on mutual funds are related. Indexation means recalculation of the purchase price after you adjust the returns based on the inflation index.
The indexation is currently applicable only to long-term capital gains tax on debt mutual funds in India. The final asset value upon adjusting for inflation decreases the taxable capital gains which reduces the investor’s tax liability from the investment. So, the indexation will be applied to the long-term capital gains to reduce the tax to get higher returns.
As an investor in debt funds, if you sell any debt fund units after a holding period of 36 months, the profits will fall in the long-term capital gain category and be eligible for the lower tax outgo resulting from indexation.
Conclusion
Paying taxes is the responsibility of every Indian citizen, and the higher the gains, the higher the taxes. However, if you understand how tax on mutual funds in India works, you will be able to time your purchase/redemption of mutual fund units in a tax-efficient manner.
Frequently Asked Questions
1. Will indexation offer me relief from tax on mutual funds?
Indexation will decrease your overall long term capital gains from debt fund investments, helping you save tax to earn higher returns. However, short term investment i.e. investment for less than 3 years in Debt Funds do not qualify for this benefit.
2. Is TDS deducted from mutual fund returns?
Currently, mutual fund companies i.e. Asset Management Companies do not deduct TDS from capital gains returns from mutual fund. Investors have to declare their returns and pay tax at the appropriate rate to the tax authorities. On the other hand, 10% TDS is applicable to dividend pay-outs from IDCW option of mutual funds.
3. Can mutual funds help me save tax?
Yes. If you invest in ELSS tax saver mutual funds, you can get tax deduction benefits of up to Rs. 1.5 lakh in a financial year under Section 80C of the Income Tax Act.
4. Are returns from all mutual funds taxable?
Yes. Returns from all mutual funds in India are currently taxable. However, long-term capital gains from equity mutual funds up to Rs. 1 lakh in a financial year are currently tax-free.
5. When was Dividend Distribution Tax on mutual funds discontinued?
Dividend distribution tax on mutual fund dividends was discontinued from 1st April 2020 as per an announcement made in Union Budget 2020.
Sources:
https://www.incometaxindia.gov.in/Pages/utilities/Notified-Mutual-Fund.aspx
https://www.mutualfundssahihai.com/en/what-dividend-distribution-tax
https://www.moneycontrol.com/msite/kotak-article-page/avoid-tds-on-mf-dividends-by-submitting-these-forms-6555141.html
https://www.etmoney.com/mf/taxation-in-mutual-funds
https://www.amfiindia.com/investor-corner/knowledge-center/tax-corner.html
https://www.mutualfundssahihai.com/en/What-are-the-taxation-rules-and-implications-in-Mutual-Fund
https://www.etmoney.com/mf/elss-mutual-funds
https://tax2win.in/guide/dividend-mutual-funds
https://www.mutualfundssahihai.com/en/What-are-the-taxation-rules-and-implications-in-Mutual-Fund
https://scripbox.com/tax/security-transaction-tax/#what-is-securities-transaction-tax
https://www.moneycontrol.com/news/business/personal-finance/explained-all-about-debt-fund-taxation-and-indexation-6618151.html
https://www.forbes.com/advisor/in/investing/what-is-elss-and-how-does-it-work/
ARN No: Oct22/Bg/03A
