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Mutual Fund Taxation – How mutual funds are taxed?

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Individuals make investments in various options with the view of enjoying capital appreciation. Mutual funds are one such option which has the potential to offer capital gains. This article has covered the following:

1. Mutual Funds Holding Period and Taxation

The period over which investors stay invested in a mutual fund scheme is known as the holding period. The holding period plays a critical role in determining the tax implications of an investment.

2. Types of Holding Periods

a. Long-Term Holding Period

In the case of equity mutual funds, a holding period of 12 months or more is regarded as ‘long term’. However, in the case of debt funds, the investment is considered long term if the holding period exceeds 36 months.

b. Short-Term Holding Period

Equity investments are considered ‘short term’ if the holding period is less than 12 months. Debt funds held for less than 36 months are regarded as short term.

The following table shows the classification of the holding period of mutual funds:

 

Funds

Short-term

Long-term

Equity funds

Less than 12 months

12 months and more

Balanced funds (equity-oriented)

Less than 12 months

12 months and more

Balanced funds (debt-oriented)

Less than 36 months

36 months and more

Debt funds

Less than 36 months

36 months and more

Hybrid equity-oriented funds (equity exposure of more than 65%) are considered as equity funds for taxation. If the equity exposure in a hybrid fund is less than 65% or is equally exposed to equity and debt instruments, i.e. 50% equity and 50% debt, then it is considered as a debt fund for taxation.

3. Taxation on Mutual Funds

a. Equity Equity Funds

Both tax-saver and regular equity funds are considered the same for taxation. LTCG tax is applicable on equity funds at the rate of 10% if the capital gains exceed Rs 1 lakh a year, and there is no benefit of indexation. However, ELSS funds differ from the regular funds when it comes to the lock-in period. While most regular equity funds do not have a lock-in period, ELSS funds come with a lock-in period of three years. Meaning, the redemption of ELSS mutual funds can be made only at the end of the lock-in period.

Note: The limit of 1 lakh is cumulative of capital gains on all equity instruments such as stocks and equity mutual funds.

b. Debt Funds

Long-term capital gains on debt fund are taxable at the rate of 20% after indexation. Indexation is a method of factoring inflation from the time of purchase to sale of units.
Indexation allows inflating the purchase price of debt funds to bring down the quantum of capital gains. You are required to add short-term gains from debt funds to your overall income. They are subject to short-term capital gains tax (SCGT) and is taxable as per the income tax slab you fall under.

c. Balanced Funds

Balanced funds are taxable depending on their equity exposure. Hybrid equity-oriented funds are taxed as any other equity fund while hybrid debt-oriented funds are taxed as any other debt fund.

d. SIPs

Systematic investment plans (SIP) are a method of investing in mutual funds. They are designed such that investors can invest a small sum periodically. Investors are given the complete liberty to choose the frequency of their investment. It can be weekly, monthly, quarterly, bi-annually, or annually. The taxation of mutual funds depends on the mode of investment.

The taxation of SIP investment is done on a pro-rata basis. Each SIP, treated as a new investment, attracts taxes on its gains separately.

For instance, you initiate a SIP of Rs 10,000 a month in an equity fund for 12 months. Each SIP is considered to be new investment. Hence, after 12 months, if you decide to redeem your entire accumulated corpus (investments plus gains), all your gains will not be tax-free. Only the gains earned on the first SIP would be tax-free because only that investment would have completed one year. The rest of the gains would be subject to short-term capital gains tax.

e. Securities Transaction Tax (STT)

Apart from these, there is another type of tax called the Securities Transaction Tax (STT). An STT of 0.001% is levied by the government (Ministry of Finance) when you decide to sell your units of an equity fund or a hybrid equity-oriented fund. There is no STT on the sale of debt fund units.

4. Conclusion

The longer you hold onto your mutual fund units, the more tax-efficient they become. The tax on long-term gains is comparatively lower than that of the tax on short-term gains.

Do you find the information taxing? Many do. That is why ClearTax has an LTCG tax filing and advisory service that you can make use of every financial year. You are just one click away from simplifying your taxes.