Taxes, like death, are an inescapable part of an investor’s life. With your mutual fund investments too, if you don’t pay attention to taxes, they might kill off a good part of your gains. The taxation rules for shares and simple derivatives are very straightforward but when it comes to mutual funds, a little more attention is required. There are different taxation rules for equity and non-equity mutual funds. This article explains the basic rules for an individual or Hindu Undivided Family (HUF) investor

Dividends

All dividends, declared by equity or non-equity mutual funds are tax-free in your hands but a Dividend Distribution Tax (DDT) is to be paid by the mutual fund house on the dividends they declare on their debt funds. There is no DDT paid by the mutual fund on dividend declared by equity mutual funds.

Dividend Stripping

Capital gains are calculated on mutual fund investments as well. In cases where dividends are paid, the tax authorities first determine whether the investor remained invested in the mutual fund 3 months before and 9 months after the dividend declaration. If not, the tax authorities will add up the dividend and the redemption amount to decide a capital loss or gain. This especially affects a practice called “Dividend Stripping” where investors incur a capital loss on investments due to the payment of dividends. Let’s take an example.

Suppose, on 1 January you invest into a mutual fund, with the NAV at Rs20. On 30 January the NAV rose to Rs21 and on 31 January, the fund declares a dividend of Rs3 per unit. So the NAV on 31 December is Rs18, assuming there is no change in the markets. You decide to redeem your units on 1 February when the NAV is Rs18, again assuming no change in the markets.

It would seem that you have incurred a capital loss of Rs2 per unit; although you have received a dividend of Rs3 per unit, you have incurred a capital loss of Rs2 per unit in the sale. The practice is called as dividend stripping.

However, in this example, the tax authorities will add up Rs18 (the redemption amount) and Rs3 (the dividend) and subtract it from Rs20 (the initial investment), which leads to a gain of Rs1 per unit - this money is liable to be taxed. It is important to bear in mind that this rule is applicable on all dividend-paying mutual funds.

Short-term and Long-term Capital Assets and Gains

Under Section 2(42A) of the Income Tax Act, a unit of a mutual fund is treated as short-term capital asset if held for less than 12 months. Units held for more than twelve months are treated as long-term capital assets. Hence, if you buy units of a mutual fund on 1 January 2008 and if you sell the units on 1 January 2009 or earlier, the gains from the investment come under the purview of short-term capital gain tax rules. Suppose you redeem the fund units on 2 January 2009, then the gains from the investment come under the purview of long-term capital gain tax rules.

Taxes and Equity Mutual Funds

Taxation rules on equity mutual funds are relatively simple. For taxation purposes, a mutual fund is considered an equity mutual fund if its portfolio consists of at least 65% of equity and equity-related instruments.

Short-term capital gains on equity mutual funds are taxed at 15% (plus education cess, applicable surcharge).There is no long-term capital gains on equity mutual funds.

Taxes and Non-equity Mutual Funds

Non-equity mutual funds are debt funds and fund of funds which invest outside India.

Dividend Distribution Taxes on Non-equity Mutual Funds

The Dividend Distribution Tax (DDT) for non Liquid/Money market funds (debt funds and Fund of Funds) is 14.163% (12.50% + 10% surcharge + 3% education cess). The dividend distribution tax for Liquid/Money market funds is 28.325% (25% + 10% surcharge + 3% education cess). The DDT is paid by the fund before distributing the dividends.

Short-term Capital Gains on Non-equity Mutual Funds

The short-term capital gains on non-equity mutual funds are added to your total taxable income and the tax is deduced from the suitable slabs. The tax slabs for Men, Women and Senior Citizens are as follows: