Mutual Fund Taxation – How Mutual Funds Returns are Taxed?

Understanding Taxation is helpful, if you're considering or already engaged in Mutual Fund (MF) investments. The returns from MFs are subject to Taxation, much like other asset classes. Being aware of the tax rules is a legal obligation and a strategic move to optimise your overall tax outgo.

This blog aims to provide you details on Mutual Fund Taxation, covering various elements to empower you in making informed investment decisions.

An Overview of Taxation on Mutual Funds

Taxation on MFs involves the obligations associated with investing in these financial instruments. Capital gains arising from the sale of units are categorised as either short or long-term, depending on the holding period.

The gains are considered short-term and taxed at the investor's applicable Income Tax Rate, if held for less than three years. Gains from units held for more than three years are treated as Long-Term Capital Gains (LTCG).

Key Factors Influencing Mutual Fund Taxation

Understanding Mutual Fund Taxation involves breaking down the concepts into four key factors:

• Type of Funds:

  Mutual Funds are classified into two categories for taxation - equity and debt-oriented

• Capital Gains:

  These are profits generated when selling a capital asset for a higher price than its cost

• Dividend:

  The distribution of profits accumulated by the MF house to its investors in the form of dividends

• Holding Period:

  The duration for which an investor holds MF units, influencing the tax rate on capital gains. Longer holding periods attract lower tax rates.

How Profits are generated in Mutual Funds

Investors derive profits from MFs through capital gains or dividend income. Capital gains result from selling units at a higher value than their cost, realised only at the time of redemption. Dividends are distributions of profits made by the fund house, becoming taxable as soon as they're paid out to investors.

Taxation on Dividends

Post the Finance Act of 2020, which withdrew the Dividend Distribution Tax (DDT), dividend income from MFs became fully taxable in the hands of investors. Tax Deducted at Source (TDS) is applicable, with a 10% deduction by the Asset Management Company (AMC) if the total dividend paid exceeds Rs 5,000 in a financial year. Investors can claim this TDS when filing taxes.

Taxation on Mutual Fund Capital Gains

The tax on capital gains depends on the type of MF scheme and the holding period. LTCG and Short-Term Capital Gains (STCG) are terms associated with the duration of holding.

Scheme Orientation

After identifying your holding period, the taxation of capital gains depends on the MF category in which you have invested.

Taxation on Equity Funds

• LTCG on Equity Funds:

  Taxed at 10% on gains exceeding Rs 1 lakh, without indexation benefits

• STCG on Equity Funds:

  Taxed at 15% on gains, applicable irrespective of the investor's Income Tax slab.

Tax on Equity-Linked Savings Scheme

Equity-Linked Savings Scheme (ELSS) is an MF that puts at least 80% of its money into stocks. If you're thinking about the tax benefits of MFs, ELSS is a good choice. When you invest in ELSS, you can deduct the amount (up to Rs 1.5 lakh) from your taxable income under section 80C of the Income Tax Act, 1961.

It's essential to note that section 80C has a maximum limit of Rs 1.5 lakh. If you're already claiming deductions for other things under section 80C, the amount you can deduct for your contributions to ELSS will be reduced accordingly.

ELSS has a lock-in period of 3 years. Once you invest in ELSS, you will be subject to LTCG and not STCG Tax. You can only withdraw the money you invest in ELSS after 3 years, but you can take a Loan against it.

Taxation on Debt Funds

Post the Union Budget of 2023, Debt Funds have no indexation benefit. LTCG and STCG from Debt Funds are taxed per the investor's applicable Income Tax Slab rate.

Taxation on Hybrid Funds

The tax treatment of Hybrid Funds depends on their orientation: equity-focused or debt-focused. Equity-focused Hybrid Funds attract a 10% tax on LTCG exceeding Rs 1 lakh without indexation and 15% on STCG. Debt-focused Hybrid Funds attract a 20% LTCG Tax with indexation benefits and STCG as per the investor's Income Tax slab.

Taxation of Capital Gains in SIPs

Systematic Investment Plans (SIPs) introduce a First-In-First-Out (FIFO) approach in determining the tax treatment of MF units redeemed. The units purchased first through SIPs and held for over a year are considered long-term holdings, with no tax on gains below Rs 1 lakh. Units from the second month onwards, attract a flat 15% STCG Tax.

Securities Transaction Tax

In addition to taxes on dividends and capital gains, Securities Transaction Tax (STT) is levied on the purchase or sale of units of equity funds or hybrid equity-oriented funds. It is typically 0.001% of the transaction value, excluding debt fund transactions.

Declaring Mutual Fund Investments in ITR

Proper disclosure is essential in the Income Tax Return (ITR), when redeeming MF investments.

Conclusion

Understanding how Mutual Fund Taxation works is about knowing how long you've kept your investment and what kind of fund it is. While the basics are simple, doing the tax math by hand, can be tricky. Keep an eye on the tax rules for different funds - whether they are stocks, debts or a mix. It helps make taxes less confusing and lets you make smart choices for your money.

Additionally, ICICI Bank can assist you in managing the complexities of Mutual Fund Taxation, providing valuable insights and guidance for better financial planning.