Says the phrase: you can’t escape death and taxes. In this article, we look at the updated rules regarding tax on mutual funds as per the Finance Bill 2020. We shall examine the tax implication on short term & long term capital gain on equity & debt instruments. We also look at the recent budgetary implications on dividend option in mutual funds.
What is covered in this article?
Rates of Tax on Mutual Funds
Tax rates charged to investors depend on the asset class. In other words, the tax rates are different for equity mutual funds and debt mutual funds.
It is important to note that tax on mutual funds is chargeable only on the gains made by the investor. No tax can be applied on the principal or invested amount.
The tax rates also depend on the type of investor which can range from Resident Indian individuals to a Hindu Undivided Family to Domestic Companies, NRIs and even Foreign Companies.
Tax on Capital Gains in Equity Mutual Funds
As per the Finance Bill, 2020 the tax rates on equity mutual funds are –
| Type of Investor | Capital Gain Tax | |
| Short Term | Long Term | |
| Resident Individual / HUF / AOP / BOI | 15% | 10% |
| Resident Partnership Firms | 15% | 10% |
| Domestic Companies | 15% | 10% |
| NRIs | 15% | 10% |
| Foreign Companies | 15% | 10% |
| FPIs | 15% | 10% |
What is Short Term Capital Gains?
Short Term Capital Gains are profits arising on the transfer or redemption of equity-oriented units held for a period of less than 12 months.
E.g. you bought 100 units in an equity mutual fund on 1-Jan-2019 at ₹100 and sold 60 units on 17-Nov-2019 at ₹150. The short term capital gain will be calculated on the units you sold i.e. 60 units. You bought these units at ₹100 and sold at ₹150 netting a profit of ₹3,000 (₹50 * 60). The short term capital gain tax shall be applied on these ₹3,000. The current short term capital gain is 15%, so that’s ₹3000 * 15% = ₹450.
The tax on short term capital gain is higher than the long-term capital gain. This is because the nature of investments for a period of less than 1 year is generally speculative
What is Long Term Capital Gains?
Long Term Capital Gains are profits arising on the transfer or redemption of equity-oriented units held for a period of 12 months or more.
E.g. you kept the 40 units beyond an year and redeemed these on 2-Feb-2020 at ₹170. The period of holding was over 12 months and hence long term capital gain tax shall apply on the profits. The long term capital gains in this transaction are 40 units * ₹70 = ₹2,800. The current long term capital gain tax rate is 10%. Hence, the tax applicable is ₹280.
Remember: Long term capital gains on equity funds which are realised after 31st March 2018 will be exempt upto ₹1,00,000 in a financial year. Thus, the tax of 10% mentioned in the table above shall be levied only if the long term capital gain on shares & equity funds (put together) exceeds ₹1,00,000 in one financial year without the benefit of indexation.
We shall learn about indexation when we understand tax of debt mutual funds.
Tax on Dividend Income in Equity Mutual Funds
Before we see the new structure, let’s spend some time on the existing structure which lasts until 31 March 2020. Here, there is no dividend tax in the hands of the investor. However, equity mutual funds are subject to dividend distribution tax (DDT). This DDT is calculated at 10% plus surcharge and cess.
And now the U-turn.
In the new structure that starts for 1 April 2020, the DDT has been abolished and the dividend is now taxable at the hands of the shareholder or mutual fund unit holders.
As per the Finance Bill, 2020 the tax on dividend income on equity mutual funds are –
| Type of Investor | Dividend Income |
| Resident Individual / HUF / AOP / BOI | As per slab rates |
| Resident Partnership Firms | 30% |
| Domestic Companies | As per applicable rates |
| NRIs | As per slab rates |
| Foreign Companies | 20% |
| FPIs | 20% |
Tax on Capital Gains in Debt Mutual Funds
As per the Finance Bill, 2020 the tax rates on debt mutual funds are –
| Type of Investor | Capital Gain Tax | |
| Short Term | Long Term | |
| Resident Individual / HUF | As per slab rates | 20% (i) |
| AOP / BOI | As per slab rates | 20% (i) |
| Domestic Companies / Firms | 22% / 25% / 30% | 20% (i) |
| NRIs | As per slab rates | 20% (i) for listed units 10% (x) for unlisted units |
| Foreign Companies | 40% | 20% (i) for listed units 10% (x) for unlisted units |
| FPIs | 30% | 10% |
(i) means with indexation benefits
(x) means without indexation benefits
Let’s come back to indexation after understanding short and long term capital gain in debt mutual funds. The STCG and LTCG are vital to the understanding of the tax structure of debt funds
What are Short Term Capital Gains in Debt Funds?
Short Term Capital Gains in debt mutual funds are profits arising on the transfer or redemption of equity-oriented units held for a period of less than 36 months.
E.g. you bought 100 units in an debt mutual fund on 1-Jan-2017 at ₹100 and sold 60 units on 17-Nov-2019 at ₹150. The short term capital gain will be calculated on the units you sold i.e. 60 units. You bought these units at ₹100 and sold at ₹150 netting a profit of ₹3,000 (₹50 * 60). The short term capital gain tax shall be applied on these ₹3,000. The current short term capital gain is your tax slab (which is 30% in my case), so that’s ₹3000 * 30% = ₹900. (I am ignoring surcharge & cess for simplicity sake)
The tax on short term capital gain is higher than the long-term capital gain. This is because the nature of investments for a period of less than 3 years is generally speculative. The government wants consumers to invest in longer term assets which are less speculative and more investible money.
What are Long Term Capital Gains in Debt Funds?
Long Term Capital Gains are profits arising on the transfer or redemption of equity-oriented units held for a period of 36 months or more.
E.g. you kept the 40 units beyond three years and redeemed these on 2-Feb-2020 at ₹170. The period of holding was over 36 months and hence long term capital gain tax shall apply on the profits. The long term capital gains in this transaction are 40 units * ₹70 = ₹2,800. The current long term capital gain tax rate is 20%. Hence, the tax applicable is ₹280 — but wait — we have not yet factored in the indexation benefits. Once we do that the tax will come down even further
Read on!
In the next section we shall look at indexation and how this can give debt mutual funds a formidable advantage.
What is Indexation?
Indexation is a technique to adjust income payments by means of a price index in order to maintain purchasing power.
Let’s understand with a simple example.
Let’s say, in the year 2004, you have bought an asset (a piece of land) for ₹10,00,000. Now, you are looking to sell it in 2018 when this land is worth ₹20,00,000. During the same period, inflation has grown by 5% per annum.
The concept of long term capital gain is derived from these three variables –
- the purchase price of the asset (₹10,00,000)
- the sale price of the asset (₹20,00,000)
- inflation (5% per annum)
Between 2004 and 2018 i.e. 14 years, your asset could have grown at the rate of inflation. Had this happened – our ₹10,00,000 would have grown to ₹19,79,931. Incredibly, this number is so very close to our selling price of ₹20,00,000. And this makes us conclude that our real estate price growth has simply matched the rate of inflation in the economy.
Now the concept of long term capital gain accounts for inflation in it’s calculation and allows investors to avoid the effects of inflation when arriving at capital gain. In other words, the tax authorities are saying that the gain you make over inflation is the real capital gain.
How nice of them!
So, in our illustration, capital gain will not be charged on the difference between ₹20,00,000 (selling price in 2018) and ₹10,00,000 (purchase price in 2004). Instead long term capital gain is the difference between ₹20,00,000 (selling price in 2018) and ₹19,79,931 (inflation adjusted purchase price in 2018).
Hence, the capital gain on which tax is payable is just ₹20,069. The long term capital gain on land (that is no agricultural land) is calculated at 20%. This means you’ll pay a tax of just ₹4,013 (i.e. 20% on ₹20,069)
How to Use Indexation in Debt Mutual Funds
If you sell your investments in debt funds after three years, the gains are treated as Long Term Capital Gains or LTCG. LTCG is taxed at 20% with indexation benefits in India.
Let’s understand this with an illustration.
I purchased ₹1,00,000 worth of units in the Franklin India Dynamic Accrual Fund on 19 March 2009. I sold all units on 05 April 2018 for ₹2,35,000. So I have the purchase and the sale price with me.
Finally, I need to calculate the inflation. Since this can be a cumbersome and subjective exercise, in India, we use the cost inflation index table which is available on the incometaxindia.gov.in website
Remember this below.
The purchase was done in March of 2009 i.e. in financial year 2008-2009 and the sale was done in April 0f 2018 i.e. in financial year 2018-19. Hence you have to use the cost inflation index values of FY2008-09 and FY2018-19 for purposes of indexation calculations. Donot try to find the difference between the sale date and the purchase date because the income tax calculations for indexation is on a financial year basis and not on a holding period basis.
Let’s look at the index value for the buy and sell years
- Index value for FY2008-09 : 139
- Index value for FY2018-19 : 280
Hence, your adjusted purchase price is ₹1,00,000 multiplied by 280 divided by 139. This comes to ₹2,01,438.
Next step.
Subtract the adjusted purchase price (₹2,01,438) from the sale price (₹2,35,000) and you will get the long term capital gain from this transaction. This comes to ₹33,561.
And finally.
Calculate the tax of the long term capital gain i.e. 20% on ₹33,561. This arrives at your LTCG tax of ₹6,712
Indexation helps investors save taxes on long-term debt mutual funds.
As seen in the illustration above, long term capital gain tax was paid only on ₹33,561 although the actual difference between the sale and the purchase price was ₹1,35,000.
Tax on Dividend Income in Debt Mutual Funds
In the Finance Bill 2020, debt mutual fund investor have emerged as winners.
Earlier, debt mutual funds were subject to high DDT of 29.12%. This was good for investors in the higher tax brackets but not as much for investors in the lower tax slabs.
In the new rules, DDT has been abolished for debt mutual funds and instead the dividend income is applicable at the hands of the investor at the applicable tax slab.
| Type of Investor | Dividend Income |
| Resident Individual / HUF | As per slab rates |
| AOP / BOI | As per slab rates |
| Domestic Companies / Firms | As per applicable rates |
| NRIs | As per slab rates |
| Foreign Companies | 20% |
| FPIs | 20% |
I hope you liked this article on tax on mutual funds. I have compiled this information from many sources and will be utilising it for managing my own portfolio aswell. You are requested to consult your tax advisor from time to time for greater details as tax laws are complicated and change often
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