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Mutual Fund & Taxes
October 14, 2009

Gains from any investments are taxed including that from mutual funds. This article helps you to calculate the tax liabilities arising from your mutual fund investments


Author : Manjunath Gaddi



Untitled Document

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:

Men aged below 65 years

Women aged below 65 years

Senior Citizens aged above 65 Years

Up to INR 160,000

NIL

Up to INR 190,000

NIL

Up to INR 240,000

NIL

INR 160,001 to INR 300,000

10%

INR 190,001 to INR 300,000

10%

INR 240,001 to INR 300,000

10%

INR 300,001 to INR 500,000

20%

INR 300,001 to INR 500,000

20%

INR 300,001 to INR 500,000

20%

INR 500,001 and above

30%

INR 500,001 and above

30%

INR 500,001 and above

30%

Sourcce: iFAST Compilations
Plus applicable Cess

To explain short-term capital gains taxes on non-equity mutual funds consider the following scenario:

A male, aged 40 and earning Rs400,000 per year makes a capital gain on debt mutual funds of Rs50,000. The income considered for income tax computation will be Rs400,000 + Rs50,000 = Rs450,000. So, for the initial Rs160,000, he pays no tax, then from the Rs160,001 to Rs 300,000 he pays 10% as tax i.e.

10% of (Rs300,000 - Rs160,001) = 10% of Rs 140,000 = Rs 14,000.

He then pays 20% tax for income between Rs 300,001 to Rs450,000.

20% of (Rs450,000 - Rs300,001) = 20% of Rs150,000 = 30,000.

In total, the man pays Rs44,000 plus applicable surcharges and education cess in taxes.

Long-term Capital Gains on Non-equity Mutual Funds

In case of Long-term Capital Gains, you have two options of calculating the tax:

Option 1: 10% without indexation (plus surcharge of 10%)

Option 2:  20% with indexation (plus surcharge of 10%)

You have to pay the lower of the two values as calculated above.

Let us consider the following situation; an investor invests into the growth option of a debt fund Rs100,000 on 1 April 2005, and redeems the investment on 30 April 2007 for Rs130,000. The investor has made long-term capital gains of Rs30,000.

Under option 1, the investor needs to pay 10% of Rs30,000 = Rs3000 as long-term capital gains tax

Under option 2, we need to use the Cost Inflation Index (CII) values released by the Income Tax department every year. The recently released CII for 2009 is available here

The formula used for calculation is:

Indexed   capital Investment = Rs100,000 *(551/497) = Rs100,000 * 1.108651= Rs110,865.2

Long-term Capital Gains = Redemption Amount - Indexed capital Investment

Long-term Capital Gains = Rs130,000 – Rs110,865.2 = Rs19134.8

Tax on Long-term Capital Gains = 20% of Rs19134.8 = Rs3826.96

The investor needs to pay Rs3826.96 as the long-term capital gain tax under option 2.

The investor will pay the lower of Rs3000 and Rs3826.96 i.e. Rs3000 as the Long-term Capital Gain Tax.

Conclusion
Until the new proposed tax code comes into effect, the above mentioned rules and regulations can be used by mutual fund investors to calculat taxes on mutual fund investments.



iFAST and/or its content and research team’s licensed representatives may own or have positions in the mutual funds of any of the Asset Management Company mentioned or referred to in the article, and may from time to time add or dispose of, or be materially interested in any such. This article is not to be construed as an offer or solicitation for the subscription, purchase or sale of any mutual fund. No investment decision should be taken without first viewing a mutual fund's offer document/scheme additional information/scheme information document. Any advice herein is made on a general basis and does not take into account the specific investment objectives of the specific person or group of persons. Investors should seek for professional investment, tax, and legal advice before making an investment or any other decision. Past performance and any forecast is not necessarily indicative of the future or likely performance of the mutual fund. The value of mutual funds and the income from them may fall as well as rise. Opinions expressed herein are subject to change without notice. Please read our disclaimer in the website.

 


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