Taxation on Liquid Funds in India

Liquid fund taxation in India depends on the date of investment and the holding period. Gains on investments made before 1 April 2023 may qualify as long-term capital gains after 24 months, while investments made on or after this date are taxed as short-term capital gains at slab rates, regardless of holding period.

What are Liquid Funds?

• Liquid funds are a debt mutual fund that prioritizes two things: easy access to your cash and predictable returns. They achieve this by investing in short-term debt instruments, typically maturing within 91 days. 
• These instruments include money market options like treasury bills, commercial paper, and certificates of deposit. 
• The return of a liquid fund depends on the market price of the securities held by the fund. While short-term securities typically experience less fluctuation compared to long-term bonds, liquid funds offer relatively stable returns compared to other debt funds.

Tax on Liquid Funds

Liquid funds offer high liquidity and the potential for steady returns, making them a popular choice for investors. However, understanding how taxes apply to liquid fund investments can be confusing. Let's break down how taxes apply to your liquid fund investments.

Understanding the Holding Period

The key factor determining the tax treatment of your liquid funds is the holding period, which refers to how long you hold the investment before redeeming it. For investments made on or after 1st April 2023, the capital gains are always treated as short term irrespective of holding period. 

However, for investments made before 1st April 2023, there are two categories for holding periods:

• Short-term Capital Gains (STCG): If you redeem your liquid fund units within 24 months of purchase, any gains you make are considered STCG.
• Long-term Capital Gains (LTCG): If you hold your liquid fund units for more than 24 months , the gains are categorized as LTCG.

Tax Implications of each Category

Short-Term Capital Gains (STCG)

• STCG from liquid funds is added to your total income and taxed according to your income tax slab rate. This means the tax rate will depend on the total income you earn in a financial year.
• For example, if you fall under the 30% tax bracket and earn a short-term capital gain of Rs. 10,000 from your liquid fund, you'll pay Rs. 3,000 (10,000 * 30%) as tax.

Long-Term Capital Gains (LTCG)

• As already mentioned, long term capital gain implications dont arise for investments made on or after 1st April, 2023.
• For investments made before the said date, the capital gains are taxed at 12.5% without indexation.

Dividends

Dividends received on liquid funds (mutual funds) are taxed at the income tax slab rate applicable to the assessee. Tax deducted at source (TDS) at 10% is applicable to dividends received in excess of Rs 5,000.

Example for Taxation on Liquid Fund 

Scenario 1: Short-Term Capital Gains (STCG)

• You invest Rs. 10,000 in a liquid fund on January 1, 2025.
• On April 1, 2025 you redeem your investment and receive Rs. 12,000 (Rs. 10,000 principal + Rs. 2,000 gain).

Tax Calculation

• Your short-term capital gain is Rs. 2,000 (Rs. 12,000 redemption - Rs. 10,000 investment).
• Since it's an STCG, this gain is added to your total income and taxed according to your income tax slab rate.
• Let's assume you fall under the 30% tax bracket.
• Tax liability = Rs. 2,000 (gain) * 30% (tax rate) = Rs. 600.

Scenario 2: Long-Term Capital Gains (LTCG)

• On 1st April 2021, you have invested Rs. 50,000 in liquid funds.
• On April 1, 2025 (after 4 years), you redeem your investment and receive Rs. 65,000 (Rs. 50,000 principal + Rs. 15,000 gain).

Tax Calculation

• Since the investments are made before 1st April 2023 and held for more than 24 months, long term capital gain implications arise.
• Tax liability = Rs. 15,000 (gain) * 12.5% (tax rate) = Rs. 1,875.