The income and earnings of all SEBI registered mutual funds is exempt from tax under section 10(23D) of the Income Tax Act. As the returns of the mutual fund are passed through its investors, the returns are taxed in the hands of the investors. A mutual fund distributes the returns to the investors in the form of periodic dividends and appreciation (increase) in the value of the units.
3. Holding Period: it refers to the duration for which an investor holds his investment. The capital gains tax is dependent on the holding period. Capital Gain is the difference between sale price and the acquisition cost of the investment. Since mutual funds are exempt from tax, the schemes do not pay a tax on the capital gains they earn. Investors in mutual fund schemes, however, need to pay a tax on their capital gains
Capital gains tax depends on the holding period of the investment as well as on the type of scheme the investor has invested in.
As per Finance Act, 2017, surcharge at 10% to be levied in case of individual/ HUF unitholders where the income of such unitholders exceeds Rs. 50 lakhs but does not exceed Rs. 1 crore. Further, Education cess at 3% will continue to apply on aggregate of tax and surcharge.
Where STT is not paid, the taxation of capital gains from equity products is similar to that of debt-oriented schemes
Indexation is a process by which the cost of acquisition is adjusted against an inflationary rise in the value of an asset. For this purpose, Central Government has notified cost inflation index. The benefit of indexation is available only to long-term capital gains.
Indexed cost of acquisition is computed with the help of following formula:
(Cost of acquisition of debt oriented mutual fund units × Cost inflation index of the year, the units of the debt-oriented mutual fund are sold)/ (Cost inflation index of the year, the units of the debt-oriented mutual fund were purchased)
Indexation benefit is available only in case of long-term capital gains and not short-term capital gains.
Tax is payable on long-term capital gains, after indexation, at 20% plus surcharge plus education cess.
For example, if the investor bought units of a debt-oriented mutual fund scheme at Rs 10 and sold them at Rs 15, after a period of 3 years. Assume the government’s inflation index number was 400 for the year in which the units were bought; and 440 for the year in which the units were sold. The investor would need to pay tax based on indexation.
Indexed cost of acquisition is Rs 10 X 440 ÷ 400 i.e. Rs 11. The capital gains post indexation is Rs 15 minus Rs 11 i.e. Rs 4 per unit. 20% tax on this would mean a tax of Rs 0.80 per unit. Surcharge and education cess is extra. Surcharge at 15%, is applicable where the income of Individual/HUF unit holders exceeds Rs. 1 crore. As per Finance Act, 2017, surcharge at 10% to be levied in case of individual/ HUF unitholders where the income of such unitholders exceeds Rs. 50 lakhs but does not exceed Rs. 1 crore. Further, Education cess at 3% will continue to apply on aggregate of tax and surcharge. Tax is deducted at source for NRI investors alone.
For resident individuals, there is no TDS for the dividend distribution or the re-purchase proceeds. But there is TDS for NRIs which is shown below.
STT is a tax which is levied on every purchase or sale of securities (except commodities and currency) that are listed on the Indian stock exchanges. This would include shares, derivatives or equity-oriented mutual funds units. The rate of tax that is deducted is determined by the central government, and it varies with different types of transactions and securities. STT is deducted at source by the broker or Asset Management Company (AMC), at the time of the transaction itself.
STT is not applicable in the case of debt oriented mutual fund (including liquid fund) schemes.
Dividend stripping is a strategy to reduce the tax burden, by which an investor gets tax free dividend by investing in securities (including mutual fund units), shortly before the record date(a date fixed by a Company or Mutual Fund for the purposes of entitlement of the holders of the securities to receive dividends or income) and exiting after the record date at a lower price, thereby incurring a short-term capital loss. This short-term capital loss is compensated with the tax-free dividend. Further, the investor can set off such loss against capital gains – both short-term and long, and can also carry forward the unabsorbed loss for set off in future years.
In simple words, the benefits of dividend stripping is that, on one side, the investor would earn a tax-free/exempt dividend or income and, on the other side, he would suffer a short-term capital loss i.e. difference between the NAV and ex-NAV, which is available to be utilized or carry forward by the taxpayer for reducing his present or future tax liability.
In order to discourage dividend stripping, in 2004, the tax department formed new rules u/s 94(7) that specified that:
The loss due to the sale of units in the schemes (where the dividend is tax-free) will not be available for setoff to the extent of tax-free dividend declared; if units are:
(A) Bought within three months prior to the record date fixed for dividend declaration and
(B) Sold within nine months after the record date fixed for dividend declaration.
All the above conditions should be fulfilled for applicability of section 94(7), if any of the conditions is not satisfied then this section will not be applicable.
Example: Mr X buys 100 units at rs.10 per unit of ABC mutual fund on 30th June 2017. The record date for declaring the dividend is 15th August 2017 for declaring the dividend at rs.2 per unit. The dividend received on mutual funds is exempt from tax. Thereafter Mr X sells all the units at rs.7 per unit on 30 November 2017.
Dividend from Mutual Fund Company: Rs 200
Payment made for acquiring units: Rs 1000
Capital Loss on sale of units: (10-7) x 100 = 300
So now Mr X will not be allowed to set off the entire capital loss of rs.300 but will be allowed to set off the loss after taking into consideration the amount of dividend earned from those units i.e. 300-200=100.
Mr X will be allowed to set off only Rs.100
As per section 94(8) of the Act the loss due to the sale of original units in the schemes, where bonus units are issued, will not be available for set off; if original units are:
(A) Bought within three months prior to the record date fixed for allotment of bonus units; and
(B) Sold within nine months after the record date fixed for allotment of bonus units. However, the amount of loss so ignored shall be deemed to be the cost of purchase or acquisition of such unsold bonus units.
Example: Suppose an investor buys 1000 units of a scheme at Rs10 each i.e. Rs.10000 on 10th June 2017. Thereafter, the scheme declares a 1:1 bonus issue on 14th June 2017 i.e. the investor receives 1 new unit, for every unit that was bought earlier. Now the investor would have 2000 units at a cost of Rs.10000. At this stage, if the investor sells the original unit at Rs 8 on 31 August 2017 then what will be the tax treatment?
Sale price of units=1000 x 8 = 8000
Cost of units = 1000*10 = 10000
Loss on units = 2000 (10000-8000)
Now according to section 94(8), the loss of Rs.2000 will be ignored. And this loss of Rs.2000 will be the cost of the bonus units which are 1000.
Note: This section is only applicable to mutual fund units and not to shares
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