Mutual fund investors and prospective investors must understand how their returns from mutual funds will be taxed. It is subject to taxation like other major investments you make. This means that it would be better for you to know the tax rules governing mutual funds before embarking on investing in them because taxes cannot be avoided. In addition, comprehending the tax treatment of mutual funds can help shape your decisions around this investment so as to cut down on your total tax outlay; this article explains all aspects of mutual funds taxation.

Taxation of Mutual Funds:

Taxation on mutual funds is a term used to describe paying taxes on any gains one makes from investing in a mutual fund. Usually, if you have held the units of such funds for not more than three years, then the resultant capital gains would be considered short-term and taxed as per your applicable marginal tax bracket. However, if those units are held for over three years, the gains will be treated as long-term capital gains.

You can know how tax on Mutual Funds works and plan your investments thus reducing your overall tax burden. Moreover, sometimes it could also provide some tax advantages. So get informed of its rules when investing in this instrument.

Factors Determining the Mutual Fund Taxation in India:

1. Type of funds: For taxation, mutual funds are classified into two categories: equity and debt-oriented mutual funds.
2. Capital gains: Capital gains are the gains you generate when you sell a capital asset for a higher price than its cost.
3. Dividend: A dividend is a part of the profits accumulated that the mutual fund house distributes to the investors of the scheme (i.e., dividends don’t require an investor to sell the asset).
4. Holding period: The holding period dictates the rate of tax you’ll pay on your capital gains. The greater your holding period, the less tax you’ll pay. India’s income tax regulations encourage a longer holding period, which is why holding your investment for longer reduces your tax liability.

How Do Mutual Funds Generate Profits?

Investors earn profit from mutual funds either through capital gains or dividend income. Let’s get some more details about what they are and how they differ. Capital gain is the profit generated from selling an asset at a higher value than its cost. For instance, if you hold units of a mutual fund scheme that you purchased when the NAV was ₹80, you will generate a capital gain when the price moves above ₹80, and you sell the units.

Profit from selling an asset for more than its cost is known as a Capital Gain. However, it is crucial to remember that Capital Gains are only realized upon redeeming the Mutual Fund units. As a result, the Capital Gains Tax on Mutual Funds only becomes due at redemption. Therefore, the tax on Mutual Funds redemption must be paid when the upcoming fiscal year's income tax returns are submitted.

Another way for investors in Mutual Funds to receive income from a fund is through Dividends. Based on its accumulated distributable surplus, the Mutual Fund declares Dividends. Dividends are distributed at the fund’s discretion and become taxable as soon as they’re paid out to the investors. Investors pay tax on dividends when they receive the dividend from their mutual funds. The following section contains information on the previous and current Mutual Fund dividend tax regulations.

1. Mutual Fund Dividend Taxation:

The Finance Act, 2020 introduced an amendment withdrawing Dividend Distribution Tax. Dividend income from mutual funds was tax-free for investors before March 31, 2020.

Dividend Distribution Tax (DDT) was deducted from dividends announced by fund houses before being passed on to Mutual Fund investors. If you fall under a particular income tax bracket as per the heading “Income from Other Sources”, you will have to pay taxes on the entire dividend income.

The TDS (tax deducted at source) is also applicable to dividends paid by the mutual fund scheme. Under section 194K, AMC has to now deduct TDS at a rate of ten percent from the dividends distributed amongst its Mutual Fund investors in case rules change such that total dividends paid to an investor during a financial year exceed five thousand rupees. When paying your taxes, you can offset the 10% TDS that AMC has already taken out and only pay the balance.

You can use TDS Calculator to calculate the tax deducted at source on dividend income earned through mutual funds. Using the TDS calculator ensures you avoid underpayment or overpayment of taxes while ensuring compliance with the income tax regulations.

2. Taxation on mutual fund capital gains:

Mutual funds are taxed at different rates depending on the type you have, and how long it has been since you bought its units. Let us break down these two factors.

First, let’s define the terms short-term capital gains (STCG) and long-term capital gains (LTCG). LTCG is a gain in the value of an asset that an investor has held for a long period of time, while STCG refers to a gain in the value of assets sold after a relatively short period of ownership.

As far as tax purposes are concerned, however, there are different time periods for equity schemes and debt schemes. For example, your holding period must be at least 12 months for equity-oriented schemes and 36 months for debt-oriented schemes before considering mutual funds’ capital gain as long- term. The table below provides an outline of holding periods after which any income arising will be termed either as “long” or “short”.

3. Taxation on Equity Funds:

Accordingly, equity-oriented schemes also include any mutual fund scheme that invests at least 65% of its corpus in Indian equities or equity-related instruments. All other funds would be treated as debt oriented for the purpose of taxation.

Longterm Capital Gains on Equity Funds:

LTCG arising from the sale of shares or units in an equity-oriented scheme were exempt u/s 10(38) till 2018 which changed. Presently, LTCG income tax on mutual funds (equity-oriented schemes) is levied at 10% on capital gains exceeding ₹1 lakh as stated in section 112A of the Income Tax Act,1961.

For example, if during a financial year you had made ₹1,30,000 LTCG from an equity-oriented scheme then your tax liability will be computed at 10% (plus cess and surcharge as applicable) over ₹30,000 irrespective of your slab rate under income-tax.

Short-Term Capital Gains on Equity Funds:

STCG tax on the sale of units of equity-oriented mutual fund schemes is charged at 15% as per section 111A of the Income Tax Act, 1961. For instance, if you generated ₹1,30,000 STCG from an equity-oriented scheme in a financial year, your tax will be calculated on ₹1,30,000 at 15% (plus cess and surcharge as applicable), regardless of your income tax slab. This is because the 1 Lakh exemption, as in the case of the LTCG tax, is not applicable to the STCG tax.

4. Taxation on Debt Funds:

Taxation for debt mutual funds is the opposite. In case debt investment is sold before the completion of 3 years as on 31st March 2023, it will be considered as STCG. This means that the income tax slab rate under which the investor falls will determine how much his or her income in relation to STCG will be taxed. STCG on debt mutual funds is charged as per the assesses tax slab. For instance, if your current income excluding the STCG is already more than ₹10,00,000 and you are in the highest tax bracket of 30%, your short-term capital gains tax rate will be 30% (plus cess and surcharge as applicable).

When holding period of debt investments exceeds three years, it would be referred to as LTCG. It also has a long-term capital gains tax (LTCG) of 20% with indexation benefits. Take note that indexation only applies to LTCG earned on non-equity oriented mutual funds. Indexation is a major mutual fund tax benefit because it reduces your capital gains (and therefore the tax liability) by increasing your cost of acquisition (i.e., purchase cost).

Indexed Cost of Acquisition = [CII for the year of sale ÷ CII for the year of purchase (or CII for 2001–02, whichever is earliest)] x cost of acquisition

On another note, if you sell your equity fund units the fund manager shall apply a fee equaling to STT at a rate of 0.001%. However, no such charge applies when one sells units in debt funds. Bear in mind that debt funds no longer have the benefit of LTCG. The capital gains arising from such schemes are taxable at slab rates depending upon the falling of an investor into that income bracket.

5. Taxation on hybrid funds:

Whether a Hybrid Fund is equity-focused or debt-focused determines how the Mutual Fund taxes it. All other hybrid funds are debt-focused, while those with equity exposure over 65% are considered equity-focused schemes. Depending on how much equity exposure they have, hybrid funds may or may not be subject to the same tax regulations as Equity or Debt Funds.

1. If the hybrid fund is equity-focused: LTCG is charged at 10% on capital gains exceeding ₹1 lakh (without indexation), and STCG is charged at 15%.
2. If the hybrid fund is debt-focused: LTCG is charged at 20% with indexation benefits, and STCG is charged as per the investor’s tax slab.

6. Equity-Linked Savings Scheme (ELSS) taxation:

80% of the ELSS is invested in stocks through mutual funds. If you intend to enjoy tax benefits in mutual fund, then this is the scheme for you. By investing in ELSS, you can get deductions up to Rs 1.5 lakh u/s 80C of IT Act, 1961. Note that even section 80C itself has a limit of Rs 1.5 lakhs. Provided you have other items which are deductible under u/s 80C like LIC premium, it will also reduce the amount deductible regarding your contributions to ELSS.

ELSS has a three years lock-in period attached to it. When you invest into an ELSS, it would always end up with LTCG tax and not STCG. Though there is an option where one can take a loan against their invested money but could not withdraw before the expiry of three years.

7. Taxation of Capital Gains When Invested Through SIPs:

The taxation of capital gains in respect of mutual funds (accumulated through SIPs) depends on the period of holding such units.

The redemptions made by the clients from these funds are treated in FIFO basis and thus when an investor wishes to withdraw his investment at a certain point, the first purchased units through SIP shall be considered as long-term holdings which is more than one year. The consequent gain arising from this holding will be called Long Term Capital Gain.

If long term capital gain does not exceed Rs.1 lakh, no tax is levied upon it whereas short term capital gains tax is 15% irrespective of the income slab for the customer that belongs to starting from second month onwards and applicable cess and surcharge should also be added to the total tax amount.

8. Security Transaction Tax (STT):

Dividends and Capital Gains Tax have been taxed as well as STT which stands for Securities Transaction Tax. STT applies when you buy or sell equity related MF units like pure equity funds or hybrid equity-oriented schemes. It usually takes 0.001% from your transaction value. However, there is no need to pay any STT while selling debt fund units.