Mutual funds, simply put, are financial intermediaries that allow a group of investors to pool their money together with a predetermined investment objective. The pooled money is invested in securities and assets depending upon the investment objectives of the mutual fund scheme.
Mutual funds provide an attractive investment choice since they generally offer professional management, diversification, affordability and liquidity at a cost that is typically lower than the cost of hiring portfolio managers. In addition to identifying the fund that matches the risk profile and the objectives of the investor, an awareness of the tax implications of investing in mutual funds is essential to maximising the returns from such investment.
The taxation of income or gains from mutual fund investment differs based on the investment pattern of a specific fund scheme. Schemes that invest primarily (greater than 65% of corpus) in equity shares of domestic (Indian) companies are regarded as equity-oriented funds and are taxed differently from schemes that invest less than 65% of their corpus in equity shares. Broadly, investments in mutual funds yield income in the form of distributions (dividend) and capital appreciation at the time of repurchase or redemption.
Taxation of dividend: Dividends distributed by a mutual fund (irrespective of the nature of the mutual fund scheme) are not taxable in the hands of investors and are hence earned tax free. However, the mutual fund scheme that distributes the dividend is liable to pay a distribution tax on the amount of dividend distributed.
As such, the distribution tax is paid out of the corpus of the mutual fund scheme and, therefore, has the effect of correspondingly reducing the net asset value of the units of the scheme.
Most mutual fund investors would be aware of the plethora of options that are available to investors in every mutual fund scheme. The primary distinction between the options is the manner of accumulation and distribution of gains. While in the growth option, all gains derived from investments are reinvested in the fund itself, in the dividend option, gains are distributed to unit holders periodically as dividends.
Taxation of gains on redemption or transfer: As far as the taxation of capital gains is concerned, it differs for an equityoriented fund and others. Gains on redemption or transfer of units of equity-oriented funds are exempt from tax if the units are held for a period of more than 12 months (except for corporate investors where a minimum alternate tax could be applicable on such gains). Gain on redemption or transfer of units of equity-oriented funds held for a period of 12 months or less is tax -able at the rate of 10% (plus surcharge and cess). However, all redemptions or transfer of equity-oriented funds are subject to securities transaction tax (STT) at the rate of 0.25% of the total transaction value.
In the case of non-equity mutual funds, gains arising on redemption or transfer of units held for a period of more than 12 months is taxable either at the rate of 20% (with indexation benefits) or at 10% (without indexation benefits), whichever is more beneficial to the investor. In other cases, such gains are taxable at the normal applicable tax rates.
Systematic withdrawal plans (SWPs) in mutual fund schemes are similarly taxed based on whether or not the SWP in question is an equity-oriented scheme. Generally, in the case of an equity-oriented scheme, where the investor holds the units for more than 12 months, the difference in the effective tax rate between a growth option and a dividend option is not significant.
However, in the case of other schemes under the growth option, the effective tax incidence will be lower vis-a-vis div -idend option. For short-term investments of up to 12 months, the dividend option may have the overall effect of reducing the investor’s tax liability on the realised gains.
However, it is important to note that the Indian tax laws have dividend and bonus stripping provisions. According to the provisions, any loss arising from redemption or transfer of units purchased within three months prior to the record date for dividend distribution/allotment of bonus units and sold within nine months after such date, is ignored. In the case of bonus units, the loss so ignored is considered as the cost of purchase of the units (held at such time) when these units are sold.
The income tax laws allow a deduction to the extent of Rs 1 lakh while computing the total taxable income of an individual and Hindu Undivided Family (HUF). Equitylinked savings scheme (ELSS) is an option available to taxpayers to enjoy the twin benefits of staying invested in the equity markets and enjoy the deduction under Section 80C.
ELSS have a lock-in period of three years and operate just like any normal equitydiversified scheme, as they need to invest 80% or more of their corpus in equity and equity-linked instruments. Generally, the tax implication of investing in an ELSS will be similar to any other equity-oriented fund.
Given the varying tax treatment of mutual fund schemes and the several options available under each scheme, an investor is advised to carefully analyse the income tax implications before investing in a mutual fund scheme factoring his individual investment objectives.
