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.

The tax liability on the investors is dependent upon the following factors:

• Residential Status (Resident Indian or Non-Resident India (NRI))
• Type of mutual fund scheme (Equity-oriented scheme or a Non-Equity Oriented scheme)
• Holding Period (Duration of your investment)

1. Residential status: The capital gains tax rates are determined based on the residential status of an investor. Residential status can be either ‘Resident Indian’ or ‘Non-Resident India” (NRI).
2. Fund type: An investor has an option to invest in two types of schemes-Equity oriented scheme or Non-equity oriented scheme.

• Equity-oriented schemes: MF schemes that invest at least 65% of its fund corpus into equity and equity related instruments are known as equity-oriented schemes. Examples: Large cap, Mid-cap, Balanced funds (equity oriented), Sector funds etc.
• Non-equity schemes: MF schemes that hold less than 65% of their portfolio in equities and equity related instruments are known as Non-Equity schemes / Debt funds. Examples: Liquid Mutual funds, Money Market funds, Gold funds, Infrastructure debt funds, Balanced funds (Debt oriented) etc.

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

Capital gains tax depends on the holding period of the investment as well as on the type of scheme the investor has invested in.

i) Equity-oriented schemes

• Long-Term Capital Gains: Nil:  on LTCG or Long Term Capital Gains (i.e. if an investment was held for more than a year) arising out of transactions, where STT has been paid. This applies to all categories of investors- resident individuals, domestic companies and NRIs.

• Short Term Capital Gains : 15% of the capital gain plus surcharge as applicable plus education cess @3% on STCG or Short Term Capital Gains (i.e. if investment was held for 1 year or less) arising out of transactions, where STT has been paid for all categories of investors i.e. resident investors, domestic companies and NRIs. 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.

Where STT is not paid, the taxation of capital gains from equity products is similar to that of debt-oriented schemes

ii) Debt-oriented schemes

• Short Term Capital Gains:  if an investment is held for three years or less, the capital gain is treated as Short Term Capital Gains or STCG. It is added to the income of the investor and gets taxed as per the tax slabs applicable for the investor.
• Long-Term Capital Gains: If an investment is held for more than three years, the capital gain is treated as Long Term Capital Gain or LTCG. The investor is entitled to the benefit of indexation on LTCG and the capital gains post-indexation is taxed @20% plus applicable surcharge and 3% cess.

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:

Indexed cost of acquisition =

(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.

Capital Gains Tax Rates on investment in mutual funds by NRIs for the Financial Year 2017-18 (Assessment Year 2018-19) are as follows:

1.Equity-oriented schemes

• The STCG tax rate on Equity-oriented schemes is 15%.
• The LTCG tax rate on The LTCG tax rate on equity funds is NIL

2.Non-equity schemes/Debt funds

• The STCG tax rate on Non-Equity schemes or Debt funds is as per the investor’s income tax slab rate. (Tax Deducted at Source – TDS @ 30% is applicable)
• The LTCG tax rate on non-equity funds is 20% with Indexation on listed mutual fund units and 10% on unlisted funds without indexation.

Tax Implications on Dividend received by Unitholders

1. Dividends on Equity Mutual Funds

• The dividend received in the hands of the unit holder for an equity mutual fund is tax-free.
• The dividend is also tax-free to the mutual fund house.

2. Dividends on Debt Funds

• The dividend income received by a debt fund unitholder is also tax-free.
• But, the mutual fund company has to pay a dividend distribution tax (DDT) before distributing this dividend income to its Unit-holders. DDT on Debt Mutual Funds is 28.84%.

Tax Deducted at Source (TDS)

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.

The rates of TDS for NRIs are:

Securities Transaction Tax (STT)

What is Securities Transaction Tax (STT)?

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 levied on the value of taxable securities transactions as under:

STT is not applicable in the case of debt oriented mutual fund (including liquid fund) schemes.

Dividend Stripping

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

Bonus Stripping

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