TAX IMPLICATION OF MUTUAL FUNDS

Investors often do think of tax implication when making any investment decision. Mutual funds, on the other hand, are one of the most tax friendly investment options available to Indian investors. An important point to note in mutual fund investments is that, an incident of tax arises only upon the sale of units of a mutual fund scheme. Your returns on mutual funds are taxed as dividend and capital gains. Lets have a look at taxation aspect of mutual funds:

CONCEPT OF HOLDING PERIOD:
The rate of taxation of capital gains provided by mutual funds depends on the holding period and type of mutual fund. The holding period is the duration for which the fund units were held by an investor. The holding period for taxability of mutual funds is as under: Fund Type STCG LTCG Equity funds < 12 months > 12 months Hybrid Equity-Oriented Funds Debt Funds < 36 months > 36 months Hybrid Debt-Oriented Funds
TAXATION of CAPITAL GAINS:
Equity Oriented Mutual Funds	Equity funds are those funds whose equity exposure is greater than 65% of its total portfolio. These mutual funds are taxed based on its holding period. If holding period is less than 12 months then short term capital gain tax of 15% is levied irrespective of your tax slab. If your period of holding exceeds 12 months then long term capital gain to the extent of Rs. 1,00,000/- per year is exempt from taxation and any gain exceeding the above specified limit will be taxed at the rate of 10% as long term capital gain taxed and there will be no benefit of indexation.
Debt Oriented Mutual Funds	Debt funds are those funds whose debt exposure is greater than 65% of its portfolio. Short term capital gain will be taxed if its period of holding does not exceed 36 months. These are termed as short term gains and will be added to your overall income and will be taxed as per income tax slab rate. Long-term capital gains are realised when you sell units of a debt fund after a holding period of three years. These gains are taxed at a flat rate of 20% after indexation
Hybrid or Balanced Mutual Funds	The rate of taxation of hybrid or balanced mutual fund is dependent on equity exposure of the scheme. If equity exposure is exceeds 65%, then the scheme will be taxed as equity scheme, if not then it will be taxed as debt scheme. Thus before investing in these schemes, do look at equity exposure of the scheme.
TAXATION OF ELSS FUNDS:
An investment made in ELSS funds qualifies for exemption u/s 80C of Income Tax Act, 1961 amounting to Rs. 1,50,000/-. ELSS are equity oriented mutual funds and comes with a lock in period of 3 years. Thus only LTCG is taxed for ELSS funds. Tax Rate: Long Term Capital Gain (LTCG) Tax on redemption of ELSS funds is exempted up to Rs.1 lakh. If LTCG is more than 1 lakhs, the applicable tax is 10% without indexation.
TAXATION of CAPITAL GAIN THROUGH SIP:
Unlike lump sum investments where a there is a single investment, SIP investments are spread over multiple dates. For tax purposes each instalment is considered as a fresh investment. Accordingly, the holding period for each instalment is calculated. For e.g. I start a monthly SIP in an equity scheme on 1st April 2020. On 15th April 2021, I decide to redeem the entire investment. In this case, only capital gains on the units purchased from my first instalment (invested on 1st April 2020) will be long-term capital gains as I have held them for a period greater than one year. For the remaining units,the holding period is lower than one year. Hence, the gains will be taxed at short-term rates.  The first in first out rule is followed for determining how long the units were held. First in first out means that the units bought first will be redeemed first.
TAXATION of DIVIDENDS:
Provisions of Taxability	Previously DDT was deducted by the domestic companies which resulted in tax free dividend income for the investors to the extent of dividend of Rs. 10 lakhs. Dividend in excess of Rs. 10 lakhs was taxed at the rate of 10% under the head IFOS. However, Finance Act 2020 has bought major changes in dividend provisions of mutual funds. Now the mutual fund companies would refrain from deducting DDT while distributing dividends instead dividends would be added in the total income of individual and would be taxable as per its applicable slab rate.
TDS Implication on Dividend	The Finance Act, 2020 also imposes a TDS on dividend distribution by mutual funds on or after 1 April 2020. The standard rate of TDS is 10% on dividend income paid in excess of Rs 5,000 from a company or mutual fund. (However, as a COVID-19 relief measure, the government reduced the TDS rate to 7.5% for distribution from 14 May 2020 until 31 March 2021.) For instance, Mr Vinay received dividend amounting to Rs 7,000 from an Indian company on 15th April 2021. Since his dividend income exceeds Rs 5,000, the company will deduct a TDS @10% on the dividend income which is Rs 700. Mr Vinay will receive the balance amount of Rs 6,300/-. A resident individual/senior citizen receiving dividends whose estimated annual income is below the exemption limit can submit form 15G/15H respectively to the mutual fund company paying the dividends.
Analysis: Single rate of taxation is always biased as it favours taxpayers who are in higher tax brackets and works against those who are in lower tax brackets. Previously DDT rate for equity mutual funds was 11.64% of dividend distributed. However after abolition of DDT and introduction of taxability as per individual’s slab rate, the person with slab rate above 10% end up paying more tax. The DDT rate for debt mutual funds was 29.12% of dividends distributed. However as per new provisions, the individuals with slab rate below 30% have been beneficial as they would end up paying tax as per their slab rates and not 29.12%. Advice: For Equity Scheme, individuals having taxability of above 10% of slab rate should avoid dividend schemes instead should invest in growth schemes as its STCG is 15% and LTCG tax is 10% beyond gains of Rs. 1,00,000/-   For Debt Schemes, individuals falling above highest slab rate(i.e. >30%) should completely avoid.
WHICH IS BETTER, DIVIDEND PLAN or SWP?
The above question should only be applied if one wants income on regular basis for its living. For investment purpose growth plan should only be considered as its long term taxability is just 10% above gains of Rs. 1,00,000/-.  Whether it be equity scheme or debt scheme, dividend is taxed based on your slab rates only. While SWP is taxed as capital gain after considering the holding  period. Individual falling under highest tax slab rate should always consider SWP over dividend option. To know more on SWP ,click here Besides taxation perspective, dividends are not assured but in SWP you get fixed cash flows. In prolonged bear market fund manager may simply stop dividends but they cannot stop SWP payments.

Keep sharing, Keep gaining.

 

By CA Dhruval Shah 

You may reach out to me at dhruvalcshah@gmail.com.

Disclaimer: The above blog is for knowledge purpose only. The author will not be responsible for any investment gains or loss, do consult your investment advisor before taking any investment decisions.