Every investment is made with an intent to generate returns. Whenever returns are generated, there are tax implications and mutual funds are no exception. While taxation is not that complex in the investment class, taxation is a bit complex topic in mutual funds. Mutual funds are of different types and complex formats. Add to that the tax slab of the investors fits in — taxation in mutual funds seems to be a convoluted process. Through this blog we try to simplify the taxation in mutual funds.
To understand taxation, one must first understand the types of mutual funds [https://www.rupeeting.com/blog/understanding-the-types-of-mutual-funds/]. While there are different types like debt funds, equity funds, equity linked saving schemes (ELSS), index funds, liquid funds and income funds. The broader categorisation is equity funds, debt funds and hybrid funds.
Capital Gain Tax on Mutual Funds:
While we know what mutual funds are, we might also know what capital gains are. As the name suggests capital gains means the gains one has generated on the capital invested. So, when one sells an investment at a profit, the total profit earned is called as capital gain.
Let us understand this with the help of an example. Mr. Sarabhai had invested Rs. 5,000 in mutual funds units. The investment has now appreciated by 10 per cent and is now valued at Rs. 5,500. If Mr. Sarabhai exits the investment at current level, his profit of Rs. 500 (current value Rs. 5,500 — invested capital Rs. 5,000) is considered as capital gain and is taxable.
An important note here is that a capital gain occurs only when an investment is sold. If the investor holds the mutual fund, then it is a gain in valuation and not capital gain.
Capital gains can be segregated in two types — Long term capital gains (LTCG) and short term capital gains (STCG). LTCG and STCG are different for various funds types. Let us understand this difference from the following table:
Fund type
Short-term capital gains
Long-term capital gains
Equity funds
Shorter than 12 months
12 months and longer
Debt funds
Shorter than 36 months
36 months and longer
Hybrid equity-oriented funds
Shorter than 12 months
12 months and longer
Hybrid debt-oriented funds
Shorter than 36 months
36 months and longer
How to calculate the STCG and LTCG on mutual funds?
Depending on the classification of the mutual funds scheme one has invested in, the short term or long term period is decided and then the taxation is levied. The STCG application is levied at 15 per cent. In the case of LTCG, amounts exceeding Rs. 1,00,000 (held for more than 12 months) are taxed at 10 per cent. Let us now understand how different types of mutual funds are taxed.
Taxation of Capital Gains of Equity Funds
The classification of equity funds is clearly categorised by the definition set by the mutual fund regulator Securities and Exchange Board of India (SEBI). The definition says equity funds are those funds whose portfolio’s equity exposure exceeds 65 per cent. There is STCG on redeeming equity fund units within a holding period of one year. Such gains are taxed at a flat rate of 15 per cent, irrespective of the investor’s income tax slab rate. One makes long-term capital gains on selling equity fund units after a holding period of more than one year. Such gains of up to Rs. 1 lakh a year are made tax-exempt. However, any LTCG exceeding the limit of Rs. 1 lakh attracts a tax at the rate of 10 per cent. Here, no indexation is applicable.
Taxation of Capital Gains of Hybrid Funds
While it may look complex, the simple way is to decide whether the hybrid fund is equity-oriented or debt-oriented. The rate of taxation of capital gains offered by hybrid or balanced funds is dependent on the equity exposure of the portfolio. If the equity exposure exceeds 65 per cent, then the fund scheme is taxed like an equity fund, if not then the rules of taxation of debt funds apply. Therefore, it is essential to know the equity exposure of the scheme one is invested in. Otherwise, investors might be in for an unpleasant surprise upon redemption of their fund units.
Taxation of Capital Gains of Debt Funds
As per the regulatory definition, the debt funds are those funds whose portfolio’s debt exposure is in excess of 65 per cent. As mentioned in the above table, one gets short-term capital gains on redeeming the debt fund units within a holding period of three years. These gains are added to the investor’s overall income and taxed at income tax slab rate applicable to him. Long-term capital gains are realised when investors sell the units of a debt fund after a holding period of three years. These gains are taxed at a flat rate of 20 per cent after indexation.
Indexation
In case of taxation, there is a concept of indexation as well.
Indexation is calculated as follows :
Amount Invested (CII for year of year of Sale/CII for year of purchase)
CII — Cost Inflation Index (Released every year by income tax department)
The above calculation gives us an ‘Indexed Cost’ of investment.
While we have already explained what is short term and long term period in different types of schemes, the following table shows at what rate the taxation is levied in case of capital gains.
Fund type
Short-term capital gains
Long-term capital gains
Equity funds
15% + cess + surcharge
Up to Rs. 1 lakh a year is tax-exempt. Any gains above Rs. 1 lakh are taxed at 10% + cess + surcharge
Debt funds
Taxed at the investor’s income tax slab rate
20% + cess + surcharge
Hybrid equity-oriented funds
15% + cess + surcharge
Up to Rs. 1 lakh a year is tax-exempt. Any gains above Rs. 1 lakh are taxed at 10% + cess + surcharge
Hybrid debt-oriented funds
Taxed at the investor’s income tax slab rate
20% + cess + surcharge
It is also important to remember that tax is collected on the entire value of redeemed funds and not individual funds. If, for instance, the gains from one’s entire portfolio exceed Rs. 1 lakh, only then will their income be subject to LTCG of 10 per cent.
Taxation in systematic investment plan (SIP)
SIP is considered the most efficient way of investing in mutual funds. Let us understand how taxation is done for SIPs. For SIPs, the redemption of units is processed on a first-in-first-out (FIFO) basis. Consider investing in an equity fund through a monthly SIP for one year, and then decide to redeem the investment in the 13th month. In this case, the first units purchased through the first SIP are held for a long-term and one would realise long-term capital gains on these units. If the long-term capital gains are less than Rs. 1 lakh, then one doesn’t have to pay any tax. However, investors make short-term capital gains on the units purchased through the SIPs from the second month onwards. These gains (if redeemed in full) are taxed at a flat rate of 15 per cent irrespective of one’s tax slab. One will have to pay the applicable cess and surcharge on it.
While we have explained the taxation and its impact on the overall profitability, it is important that the investors should align the mutual funds investments to financial goals.
