As more people in India begin to invest in mutual funds, one typical issue that investors have is whether the returns are taxable. After all, many other popular investments, such as recurring deposits, fixed deposits, Kisan Vikas Patra, and so on, are all taxable. Furthermore, because there are three forms of mutual funds – equity, debt, and hybrid – is the tax on mutual funds the same in all cases? Continue reading to learn about the mutual fund taxation in India.

Factors Influencing Mutual Fund Taxation in India

Here are some factors influencing mutual fund Taxation in India:

Mutual Fund Type

Mutual fund taxes are classified into two types: equity mutual funds and non-equity mutual funds. All stock mutual funds are taxed according to one set of rules, but all non-equity mutual funds are taxed according to a second set of rules.

Gain type

Taxable gains on mutual funds are created when fund units are sold at a price greater than the acquisition price. Dividends are another sort of profit generated by mutual funds. Dividends are a portion of the profit distributed by the fund manager to the investors.

Depending on the Holding Period

The taxation of mutual funds is also affected by the holding time of the mutual fund units. A long holding period is usually advantageous for investors because the tax rate is lower.

Capital gains Tax rules 

For EQUITY MUTUAL FUNDS

An equity mutual fund is one in which 65% or more of total assets are made in Indian equities or other domestic equity-oriented instruments. Equity Mutual Fund returns are taxed according to the Capital Gains taxation regulations of equity funds.

If units are held for less than a year before being sold, equity mutual fund capital gains are categorised as short term capital gains (STCG). If a unit is redeemed after one year from the date of purchase, long-term capital gains (LTCG) laws apply.

1. Long term Capital Gain 

If long-term capital gains for the fiscal year exceed Rs. 1 lakh, mutual funds are taxed at 10%. Long-term capital gains of up to Rs. 1 lakh in a fiscal year are not taxable under existing equity mutual fund taxation laws.

2. Short term Capital Gains on Equity Funds 

Short Term Capital Gains (STCG) on equity mutual funds apply if scheme units are sold for a profit within one year after purchase. The STCG tax rate on stock mutual funds is 15%, regardless of the overall short-term equity gains for the fiscal year.

For DEBT MUTUAL FUNDS

A debt fund is a type of mutual fund where a majority of assets are allocated to fixed-income investment instruments like bonds, certificate of deposits, treasury bills etc. that are traded in the bond market or money market. As an investor, you will get short-term capital gains when you redeem your debt fund units within 3 years of purchase. Short term capital gains tax on debt mutual funds are as per the income tax slab rate of the investor. However, if you sell debt fund units after holding it for three years or more, you will receive long term capital gains. Long term capital gains tax rate for debt mutual funds is 20% with indexation. 

For HYBRID FUNDS

The taxation of hybrid mutual funds is determined by the scheme’s equity exposure. If the hybrid fund’s equity allocation surpasses 65%, it will be taxed similarly to equity funds. Long-term gains exceeding Rs. 1 lakh in a fiscal year will thus be taxed at a 10% rate. As a result, short-term profits from equity-oriented hybrid funds will be taxed at 15%. Debt-oriented hybrid funds with equity allocations less than 65% will be taxed in accordance with debt mutual fund taxation guidelines. In this situation, long-term capital gains will be taxed at 20% after indexation. Short-term profits from debt-oriented mutual funds, on the other hand, will be taxed at the investor’s marginal tax rate.

For ELSS TAX SAVER FUNDS

When it comes to tax on ELSS mutual funds, investments in tax saver funds are eligible for tax benefits under Section 80C of the Income Tax Act of 1961. Remember that, while there is no maximum investment amount, you may only claim a tax deduction for up to INR 1.5 lakh in a fiscal year. Because ELSS have a three-year lock-in term, units cannot be redeemed before the first year is up. According to current equity mutual fund taxation laws, long-term capital gains from tax saver mutual fund redemption are subject to tax.

Tax on dividends offered by Mutual Funds

Dividends can be declared by any form of Mutual Fund’s IDCW option (previously known as dividend option). Dividends are totally taxable in the hands of the investor under current tax laws for mutual funds. Dividend pay outs are included to the taxable income of the investor under the title “Income from Other Sources”. This income is subsequently taxed at the investor’s applicable income tax slab rate. In some circumstances, tax deducted at source (TDS) at 10% of dividend pay-out is also applicable.

Dividend Distribution Tax for Mutual Funds

Previously, mutual funds were required to pay Dividend Distribution Tax (DDT) whenever dividends were declared and paid out to investors. Every dividend income received by the investor was tax-free under this regulation. DDT is no longer applied to dividends paid out by mutual funds as of April 2020, however dividend income is now fully taxable in the hands of the investor.

Relation between indexation and mutual fund taxation

When addressing mutual fund taxes, you need understand how indexation and mutual fund taxes are related. Indexation is the process of recalculating the purchase price after adjusting the returns based on the inflation index.

In India, indexation is currently solely applicable to long-term capital gains tax on debt mutual funds. After correcting for inflation, the final asset value reduces taxable capital gains, lowering the investor’s tax liability from the investment. As a result, indexation will be applied to long-term capital gains in order to cut taxes and achieve higher returns.

If you sell any debt fund units after a holding period of 36 months, the earnings will fall into the long-term capital gain category and be eligible for the lower tax outgo that indexation provides.

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