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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
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. An investment for less than 1 year duration is classified as Short Term.
  • 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 (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 2012-13), this amount is Rs. 200,000.
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 60K and other incomes was 150K, then the investor would have to pay 15% tax on 10K STCG (150+60 less 200K 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 will be taxed as a normal UK income under the respective tax slab of the person. In USA it may be taxed as a normal Capital Gain transaction. Hence, even though a LTCG is tax free in India, it may not be tax free in the respective foreign country where NRI is residing. However, one things is common across all countries. Till the time NRI’s don’t sell their investments in India, they are not taxable in their respective foreign countries.
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 setoff 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 :
Growth
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).
Dividend Option
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 – no DDT is deducted;
  • Liquid Funds – DDT is 25% plus surcharge;
  • All other funds (such as debt funds) – DDT is 12.5% plus surcharge. In the budget 2013, this has been amended whereby DDT on all Liquid funds and Debt funds will now attract a charge of 25% plus surcharge.
A point which is worth mentioning is that DDT can not be recovered by an investor like TDS in case the investor is not required to pay taxes. 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 would want to consider the tax impact of dividends in their respective resident countries where they may have to pay taxes on such dividend incomes.  In my experience, in most of the 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
Resident Indians
No tax is required to be deducted at source for resident tax payer by a mutual fund.
Non Residents
Unfortunately, the exemption from TDS which resident Indians enjoy is not available for NRIs. The rate of TDS for NRIs is as follows :
  1. Equity Funds – LTCG – No TDS
  2. Equity Funds – STCG – 15% TDS on profits
  3. Debt Funds – LTCG – 20% TDS on profits.
  4. Debt Funds – STCG – 30% TDS on profits

Summary of TDS(for NRIs) & DDT

Equity Funds

Debt Funds

STCG

15% TDS

30% TDS

LTCG

NIL

20% TDS

DDT

NIL

25% for Liquid Funds + Surcharge

12.5% for others + Surcharge

Conclusion
After going through above details, you would have probably got an idea about the impact of tax on your investment plan. I do agree that taxation can be a complicated matter and to get more details you may want to visit your financial advisor or tax consultant before committing a costly tax mistake. I have personally got several examples, specially NRIs, who ended up paying heavy taxes in their foreign countries due to their tax inefficient investments in India which could have been easily avoided. Good luck for your investments.

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28 Responses to Tax Implications of Mutual Funds on Residents and NRIs

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  3. Chander Goyal says:

    excellent article

  4. Raj says:

    Thanks for this Article. I used to follow your discussions in Jagoinvestor. This is the first time I am commenting in your website.

    I’ve a doubt – for a NRI what is the best option to park money short term? Bank’s short term NRE FDs at interest rate 7.5 for 180 days or Liquid fund like JM Money Manager?

  5. Kunal Gera says:

    Hi,

    I am investing 40000 pet month for long term in equity funds thro SIP, and will be going to US soon. I want to knowif I dont book profits in short term, then what will be tax implications on me in india and US.
    Thanks

  6. Raj,
    If you want to park (and not invest), then don’t take the route of NRE FDs as you may need access to your funds at any time. Liquid funds will attract high taxes. Best would be to go with HDFC Cash Management Fund – Treasury Advantage Plan – Dividend Reinvestment option. This will give you tax free return of approx 7.5% plus and you can withdraw your funds at any time. This fund is analogous to a liquid fund, but has tax liability of a debt fund.

  7. There will be no implication until you sell. Once you sell, the implication will be :
    In India – Short Term Capital Gain tax of 15% on holdings less than 1 year. Rest all will be tax free;
    For US – They have two rates, but for sure, LT Capital Gain is not tax free(approx 20%). It is taxed at a rate which is lower than the slab rate. I must admit that I will not have the exact rates.
    I will not suggest you to to book profits in your mutual funds which were bought for long term. Just stop the SIPs into these funds. Open a NRE account and make fresh contributions out of your NRE account.

  8. soma says:

    Hi,

    Thank you for this excellent article. It was easy to understand.
    I got lot of information i was looking for.
    I am a NRI and want to start investing in MFs in INDIA by opening NRE account. My question is i am planning to invest 50,000 rupees every month in equity mutual funds for a very long term(5 years).I am planning to come to INDIA after 5 years. So i withdraw after 5 years when i come back to india, what will be the tax impact?
    Thank you

  9. ramkumaran says:

    Hi, how about gold etf are they considered as equity traded funds or debt fund for long term tax gain calculation

  10. Depends on the asset class the ETF is investing into. Equity ETFs will be treated as equity shares. Others (debt) will be treated like debt for capital gain. You can read more at http://insight.banyanfa.com/different-options-to-invest-in-gold/

  11. Deepta says:

    Hi,

    I am still a bit confused abt the taxations with regard to STPs from liquid or debt funds. I plan to increase my investments in my existing fund – UTI Opportunities, through a lump sum investment in UTI Liquid Cash Plan and start weekly STPs. Keeping in mind that these STPs will be done for a time frame of over a year, i have opted for the growth option in the liquid fund. I plan to duplicate this approach with other existing equity funds with HDFC & ICICI.
    My question here is –
    1) Do these weekly/monthly STPs attract STCGs as per my slab (30%)?
    2) If yes, how do I minimize tax incurred during the STPs from the liquid fund? Will a dividend reinvestment option work out better in this case?
    3) Would a short term debt fund be better for this purpose (of course, keeping in mind exit load & lock-in periods)?

    Would appreciate any feedback. Thanks!

  12. Chander says:

    Hi Sir,
    Can you confirm the stcg on equity oriented fund, in case of nris
    you said that NRIs can not lower tax on stcg even if the total income is less than tax exempted income,
    what would be the case if fund house has not deducted the TDS of 15% on such gain, do I have to pay tax on small stcg from sale of equity funds?

  13. NRIs are subject to flat 15% tax on Equity oriented fund STCG. If the fund house has not deducted TDS, then you are required to pay it. Can you check if you have invested as a NRI or Resident Individual where the fund house is not deducting TDS.

  14. Dev says:

    Dear Team,

    I am Confused with Tax Treatment in a Case request you to Guide me on Urgent Basis.

    One of my friend had purchased HDFC – Cash Management Funds – Tresasury Advantage Plan – Retail – Dividend Plan.

    Date of Purchase was 10-04-2012 Amount of Rs.50 Lakhs.
    wherein dividend was daily Reinvested
    out of which Rs.10 Lakh were withdrawn on 06-03-2013 and remaining units got redemption on 01-10-2013 valuing Rs.4481109

    Request you to guide me on Tax Treatment of this Case.

  15. Dev
    The most simple option is to contact your fund house and ask them to provide you a capital gain statement. It will give you all the breakup. Dividend which got reinvested will not be subject to tax. For the amount which is redeemed, it will be subject to capital gain tax for which you need a detailed statement as I have mentioned above.

  16. krish says:

    Dear Sir
    I am NRI (USA), I have 50k FD in NRE account for 10 years. by this artical i come to know I can transfer interest to SIP account and buy certain MF. Then only I have to pay only capital gain tax of MF in USA.

    My Qs is all MF bought from Interest income which is taxable in USA. So Do we have to pay tax on whole MF value or MF gain value?

  17. Krish,
    Unfortunately owing to recent regulatory updates in India, none of the mutual fund houses are willing to take investments from US NRIs. Please contact us via the contact us page for more options here.

    If you had already invested in MFs, your MF gains will be taxed in US. Whole MFs are not taxable as they were purchased using NRE Interest Income which is already taxable in US.

  18. Dip Roy says:

    As you mentioned, for LTCG, I have to pay tax in UK at the time of selling depending on the tax slabs. Is there any way to avoid this? Please let me know. Thanks.

  19. Sorry Dip – We are not aware of how to avoid or plan your taxes around this query.

  20. Vikram Saini says:

    How should the capital gains be determined for a US based NRI?
    1. Sold (in Rs) – Purchased (in RS) and capital gain converted to USD
    2. Sold (converted to USD on that day) – Purchased (converted to USD on thst day)

    It’s important to know this because of different currency conversion rates at buying and selling, especially if funds are sold after many years.

    Thanks.

  21. Vikram,
    Tax laws do mention how to convert foreign incomes into local currency. Please consult with your CPA on this topic. It is also discussed on IRS’s website http://www.irs.gov/Individuals/International-Taxpayers/Frequently-Asked-Questions-About-International-Individual-Tax-Matters#ExchangeRates

  22. Kumud Taparia says:

    It was a good article. Would be grateful if it can be updated as per present tax regime as there are many changes that have taken place.

  23. I working in foreign i am a NRE with NRE account i want park money for short duration for find one home so in between i want park money to where? And i need to take any time with reasonable interst with out tax, and if i open demat account and purchase mf if get profit return any tax? Please be ans

  24. Ajay says:

    Dear Sir,

    With reference to your subject article, I have the following query.

    I am investing in lDSPBR World Gold Funds / World Mining / Other International, Liquid and Debt Mutual Funds as NRI Investor from UAE with whom India currently as Double Taxation Avoidance Agreement (DTAA).

    Based on DTAA bank applies TDS on my interest income on NRO bank fixed deposits at a reduced rate at 12.5% instead of 30% (normal rate). For this I need to submit a self declaration that I am a NRI from UAE and nothing more is required. Even this TDS can be claimed back up to a limit of 1.5Lacs income (as tax free income) by submitting a formal IT returns with the IT Department and the IT department refunds this amount by crediting back to my bank account.

    Now in mutual funds, every time I redeem funds debt / liquid / international funds (classified as debt) the TDS is being deducted at 33% by the Mutual Funds as short term capital gain tax.

    I have 2 questions / clarifications in this regard.

    1. If I provide DTTA declaration (as I provide for my bank fixed deposit account), can this TDS be deducted at a lower rate of 10% by MF?

    2. Alternatively, am I allowed to claim this as tax refund from IT Department by filing tax returns? What is the Income Tax rule in this regard with regard to the taxation for NRI for investments on debt mutual funds with reference to DTTA with UAE?

    If fixed deposit TDS are done at reduced rate based on self declaration why not the same is possible in MF? If not could you please confirm whether I can file tax returns and claim this as refund? I have no other taxable income in India!

    I have checked with couple of Charted Accountants, none of them could provide a proper answer to the above.

    Request you to clarify the above.

    Regards

  25. Ajay, we are not aware if Mutual Funds can accept a declaration to reduce your TDS. But any TDS deducted by mutual funds can be fully refunded if you have no income in India, provided you file your tax return. You don’t even need to go into the complications of DTAA. Why are you even investing via UAE – invest directly into Mutual Funds in India. Solution to your query can not be done via this query section and hence would suggest you to write us at info@banyanfa.com.

  26. Ramkumar,
    In absence of any further info, we believe a good option could be investing into NRE FDs itself as it will give you tax free interest. However, many banks will give you no interest if you invest for less than 1 year. If your tenure is less than 1 year, you should put that money into Liquid funds, but they will deduct TDS before paying you the income. You will have to claim the TDS by filing a tax return in India.

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