Taxation Rules for Mutual Funds

Most of the salaried class are guided to go for Mutual funds or ELSS to cut down on their taxes. However, many are not aware of the taxes that are levied on the capital gain income from these resources. This writeup covers the basics of the Taxation Rules for Mutual Funds in India

Basics of the Taxation Rules for Mutual Funds

There are three categories of mutual funds:

Equity, Debt, and Equity Hybrid

Note:

  • Hybrid funds are a mix of equity and debt funds with at least 65% equity, so they are taxed the same way as equity funds.
  • Mutual fund taxation only applies to gains or returns, not to principal amounts.

Debt mutual funds

Short-Term Capital Gains: Gains made on investments held for less than a year are taxed at your marginal tax rate.

Long-Term Capital Gains: A 20% tax is applied using indexation when funds are held for three years.

Stocks and equity mutual funds:

These are taxed at 15% on short-term capital gains (if held for less than 12 months) and long-term capital gains after 3 years. If gains exceed Rs. 1 lakh, they are subject to a 10% tax.

Effect of Section 194K in Taxation Rules for Mutual Funds

Before the 2020 budget, all domestic companies were subject to a DDT (Dividend Distribution Tax) when paying dividends to their shareholders, and thus the dividend income was exempt in the hands of a domestic shareholder.

After the 2020 budget, DDT (Dividend Distribution Tax) is eliminated from the budget. The shareholder is now required to pay income tax on the dividend income.

There is also TDS that must be applied.

Under Section 194K, “TDS on dividends from equity mutual funds” is now applicable.

This is based on the following:

The TDS on Dividends from Equity Shares Amendment to Section 194

When paying dividends on equity shares to residents, domestic companies must deduct TDS at a rate of 10% on amounts over Rs. 5,000.

Note: Section 195 of the Income Tax Act says that TDS must be taken out at the right rates if the shareholder is not a resident.

Effect of Section 194K on Mutual Fund Income

  • Dividend income is subject to slab rates of taxation in the hands of the shareholder.
  • If the dividend exceeds Rs. 5000, the payer will deduct TDS at a rate of 10%.
  • The shareholder may claim credit for TDS deducted when submitting an income tax return.

Indexation and debt mutual fund tax

Gains from units that are held for longer than 36 months in debt funds are long-term gains. The indexation tax on LTCG is 20%.

Indexation is essentially the process of changing a value’s price to account for inflation. The Cost Inflation Index (CII) is the amount that results from the calculation of inflation each fiscal year. The main goal is to account for price increases so that investors only have to pay taxes on their “real gains.”

Example

Let’s take an investor who first invested Rs 50,000 in a debt fund and has held units for more than three years as an example.

For the sake of simplicity, let’s say that the investor received a 10% annual return. The potential returns are Rs. 66550.

The current value of CII is 1125 for FY 2021–2022 and 1024 for FY 2017–2018, which would be the value for the base year.

Following are the steps to compute capital gains (CG) using indexation:

CG = Returns – [Initial Investment*CII base year/CII current year]

= 66550-[50000* {1125/1024}]

= 66550-[50000*1.098] .098]

= 66550- 54900

= 11650

Indexation plus tax = 11650 x 20% = 2330.

Since the profit is Rs. 16,550 (66,550 minus 50,000), the investor only needs to pay a 14% effective tax (2330/16,550).

Now that you know the Taxation Rules for Mutual Funds, Invest wisely!

While making your investments, do take into account all these factors and compare the more stable Vs volatile investments to make your rupee last longer.

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