It is very important that investors know the tax impact of mutual funds prior to investing. A tax inefficient investment can result in providing a major portion of your future returns to the tax man. To ease your investment decision, we have dedicated this article to explain the tax liability associated with different types of mutual funds. If you want to know more about Mutual Funds, then please read our other article What is a Mutual Fund.
A summary of tax implication on different types of mutual funds is as follows :
LTCG : Long Term Capital Gain (from 1 April 2018, LTCG on Equity oriented investments are subject to 10% tax)
STCG : Short Term Capital Gain
Some of the aspects associated with taxation of mutual funds are as follows :
A return is specified as Long Term if the investor has invested in the units for more than 1 year for Equity oriented fund. An investment for less than 1 year duration is classified as Short Term. For non-Equity oriented scheme, e.g. debt funds, foreign funds, instead of 1 year, the period is 3 years.
LTCG is tax free only if mutual funds are Equity Oriented. A mutual fund is classified as Equity Oriented only if it invests over 65% of its corpus into Equity Shares listed in India (as per Income Tax Act of India).
You may notice that there are two rates of LTCG in the above table for Non Equity Funds. One rate is associated with Indexation (20%), whereby the cost of purchase of mutual funds is increased to take into affect the inflation in the economy and hence reducing the net Capital Gain. Another rate is associated with a situation where the investor chooses not to opt for Indexation (10%). It is in investor’s interest to compare the tax impact by both Indexation and Non Indexation to arrive at a decision as to which rate would he / she choose for taxing their mutual funds.
No Tax upto Tax Exempt Limit
This is a blessing provided by Income Tax Act for all resident tax payers. As per the current tax laws every resident person is allowed a minimum income on which no tax would be charged. In the current year (FY 2019-20), this amount is Rs. 250,000.
You may have noticed a small * against STCG on Equity / Balanced funds. As per the current laws, such STCG is chargeable at 15% flat rate. However, if a person doesn’t have any other income or all other incomes are less than the minimum tax free income slab, then the STCG (15%) is not taxed upto the minimum tax free income slab. For example, if STCG from Equity Funds is 50K and income from all other sources is 150K, then the STCG + other incomes is 200K which is the amount on which an investor does have to pay tax and hence the investor would not be required to pay tax on such STCG.
In the above example, if the STCG was 150K and other incomes was 150K, then the investor would have to pay 15% tax on 50K STCG (150+150 less 250K tax slab).
This ‘No Tax upto Exempt Tax Limit’ is also applicable against LTCG / STCG on all fund categories mentioned in the above table.
NRI taxation in India
While filing the tax returns, NRIs have an option to be taxed in the same manner as a Resident Individual. Having said that, there are slight differences only with STCG on Equity oriented funds whereby NRIs don’t have an option for tax free STCG (on Equity Funds) as mentioned in the above paragraph for upto Tax Exempt Limit. This benefit is expressly reserved for Resident Tax payers. Hence NRI’s have to pay 15% tax on STCG on Equity Funds irrespective of their other incomes in India.
NRIs – Taxation in Foreign Countries
This is one of the most ignored aspects by NRIs while investing into Indian Funds. If LTCG in Equity Funds is tax free in India, it doesn’t mean that NRI’s are not required to pay tax on LTCG in their respective foreign country where they are resident of. Taxation in Foreign countries can be broadly classified as :
Tax Free Countries – (such as Middle East) : For NRIs residing in countries where there is no tax, in such a case they are not required to think upon secondary tax issues in their respective foreign countries as there would not be any further tax impact in such countries. Hence, the Indian taxation is what governs their tax decisions.
Other Countries – (such as UK, USA, etc.) : NRIs residing in countries where they need to pay tax on capital gains / incomes on their global assets need to think upon the impact of Capital Gains associated in India on their respective tax liabilities in such countries. For example, UK NRIs do not need to pay tax on their investments in mutual funds till they sell it. However, any Capital Gain on selling the funds may be taxed as a normal UK income under the respective tax slab of the person. In USA, the Indian mutual fund gains may be taxed on accrual basis. Yes you heard it right, on accrual basis. This may make your investments in India via mutual funds as extremely tax inefficient.
Setting off Options for Capital Gains
The netting rules between capital gains / losses are complicated, but if used properly, they can assist in reducing the net tax outflow for investors. The following rules apply for setting off these incomes & loses :
1. LTCL can be setoff against LTCG only;
2. STCL can be setoff against STCG & LTCG;
3. STCL / LTCL can not be setoff against other incomes such as interest income / house property / salary incomes.
So for example, you had a STCL of Rs. 200,000 and a STCG of Rs. 300,000. You can set off both of them together and pay tax on net STCG 100,000.
Tax Effect of Investment Options
While investing in mutual funds, investors have got broadly three options : Dividend, Growth or Dividend Reinvestment Option. The impact of taxation on each of these options are :
There is no tax impact till the time the investment is not sold. At the time of sale, the investment attracts the normal Capital Gain Tax rules (Sale – Purchase = Gain / Loss).
There are two tax impacts associated with Dividend Option.
1. Deduction of Dividend Dividend Tax (DDT) by the Mutual Fund House :
At the time of paying dividend, mutual fund houses may have to deduct DDT from the dividend amount (similar to TDS). The rates of these DDT are :
Equity schemes – 10% plus surcharge;
Debt / Liquid Funds – 25% plus surcharge;
A point which is worth mentioning is that DDT can not be recovered by an investor like TDS. For example, if an investor does not have any income subject to tax and he received a net dividend of Rs. 70,000 on which the Mutual Fund house has already deducted Rs. 30,000 DDT before paying dividend. In such a case, the investor can not claim a refund of this DDT by filing a return of income. Hence such investors should opt for Growth option rather than Dividend option while investing.
2. Dividend Tax Liability for Investor
As per the current tax laws, dividend income received by an investor is tax free. While this holds true for Resident Indians, NRI’s should consider the tax impact of dividends in their respective resident countries where they may have to pay taxes on such dividend incomes. In many foreign countries, Capital Gains are charged at a lower rate than dividends and hence NRIs may want to avoid investing with ‘Dividend’ option and may want to invest with ‘Growth’ Option. Another advantage of investing in Growth Option is that the investor can defer their tax liability upto a later date in future when they would be selling their funds. These sale in India can be timed in such a manner that it attracts minimum taxes in their respective countries.
Dividend Reinvestment Option
Dividend reinvestment option bears the same tax impact as of Dividend option. Hence, based upon the tax liability, an investor may want to avoid investing using this option and go for the ‘Growth’ option.
TDS on Mutual Funds
No tax is required to be deducted at source for resident tax payer by a mutual fund.
Unfortunately, the exemption from TDS which resident Indians enjoy is not available for NRIs. The rate of TDS for NRIs is as follows :
Equity Funds – LTCG – No TDS
Equity Funds – STCG – 15% TDS on profits
Debt Funds – LTCG – 20% TDS on profits.
Debt Funds – STCG – 30% TDS on profits
Summary of TDS(for NRIs) & DDT
*+ Surcharge & Cess
After going through above details, you would have probably got an idea about the impact of tax on your investment plan. Taxation can be a complicated matter and to get more details you may want to visit your financial advisor or tax consultant before concluding on your investment plan.