All you wanted to know about Mutual Fund taxation


"There may be liberty and justice for all, but there are tax breaks only for some."

Most of us are familiar with income tax where the level of your income from your profession determines the tax rate. Currently there are four slabs - 0%, 5%, 20% and 30%.

Just like this is not the only type of income that exists, this income tax is not the only type of 'income' tax that exists.

Income (or more correctly gains/profits) received from sale of certain assets like gold, real estate, and financial assets like Mutual Funds, stocks, bonds etc is not treated as ordinary income for taxation.

These gains are called Capital Gains (the assets are called capital assets) and the tax applicable is called Capital Gains Tax.

Capital Gains Tax depends on the asset

Unlike regular income tax which does not depend on the type of your profession (whether you are a techie working in an MNC or a plumber doing odd jobs), capital gains tax depends on the type of the asset that produced the gains - the tax on FD is different from real estate which is different from stocks and so on.

So, 1 lakh interest gained from your FD will be taxed differently from 1 lakh profit made by selling real estate, or from 1 lakh profit made in stocks or Mutual Funds. Even within Mutual Funds, equity Mutual Funds are taxed differently from non-equity Mutual Funds.

Short Term vs Long Term Capital Gains & Tax

There is another interesting concept that is applicable to Capital Gains Tax that is not seen in normal income tax -

The tax liability also depends on how long you have held the asset for i.e. the date of sale - the date of purchase.

Based on the holding period, your gains will either be categorised as Short Term Capital Gains (STCG) or as Long Term Capital Gains (LTCG). The tax applicable on STCG is called STCG Tax and that on LTCG is called LTCG Tax (duh!).

Not only this, different assets have different cut-offs for the holding period to be classified as short term or long term.

So here is the basic 'algo' for figuring out the applicable capital gains tax rate:

Capital Gains -> which asset? -> whether long term or short term (according to the asset) ?-> look up applicable tax rate for that asset for that period.

Quite a mouthful, right?

You might be wondering why all this un-necessary bother. Why can't we just tax everything like the regular income tax and be done with it?

Apart from the fact that this will lead to wide-spread unemployment amongst the CAs, the reason for going through so much trouble is that Capital Gains Tax is generally less than the income tax - in many cases even substantially less.

Just remembering this fact will make you a much smarter investor (and a nicer human being - at least towards us and your CA).

Capital Gains Tax have to be paid on your own

Most of us who are salaried or have professional income are used to the concept of TDS - Tax Deducted at Source.

One misconception about TDS is that TDS is the same as tax liability. It is not. TDS is just a way for the government to check tax evasion by asking the employer/payer to deduct some tax at the source even before the income reaches you. The concept of TDS may not even exist in other forms of income e.g. capital gains income. But that does not mean that there is no tax liability for that income.

Your final tax liability can be (and usually is, in case of non-salary income) different from the amount of TDS deducted.

If your tax liability exceeds the TDS amount then you have to pay it on your own via a payment (known as a challan) to the income tax department.

If your tax liability is lower than the TDS amount then you claim the difference as a tax-refund while filing your tax returns.

TDS on Capital Gains

There is usually no TDS on your capital gains income - i.e. while selling an investment there is no TDS deducted from your profits. This does not mean that your gains are tax-free. It just means that you need to take care of it on your own.

Now let's look at how Capital Gains Tax applies to some of the popular investment options that most of us use.

1. Fixed Deposits

This one is simple.

Firstly, interest income earned from Fixed Deposits is not tax free - it is fully taxable.

Secondly, FD is not even considered a capital asset so actually all the interest income is treated as ordinary income and taxed at your income tax level (irrespective of the tenure of FD).

So if you are in the 30% tax bracket and your bank is giving you a 7% interest on your FD, your tax liability is 30% on that interest i.e. 30% of 7% = 2.1%. So your actual after-tax interest rate is just 7 - 2.1% = 4.9%!

Similarly, if you are in the 20% tax bracket, your after-tax FD returns are going to be 7% - (20% of 7%) = 5.6%.

What about TDS?
Banks are liable to deduct TDS at the rate of 10% on the interest earned, if the interest income for the year is more than Rs. 10,000.

Again, don't confuse TDS with tax liability. Just because TDS is deducted at 10% does not mean your tax liability is also 10%. It could be higher or lower depending on your income level. Gotta keep track of it on your own.

2. Real Estate - property, land, house etc

Real estate is a capital asset so profits gained from sale of real estate come under Capital Gains.

If the holding period was less than 2 years, the gains will be marked as Short Term Capital Gains (STCG). STCG for real estate is clubbed with your total income and taxed at your income tax level.

If the holding period was more than 2 years, the gains will be marked as Long Term Capital Gains (LTCG). LTCG for real estate qualifies for indexation benefit i.e. in order to compute your gains, instead of using your actual purchase price you can use a higher inflation-adjusted price.

So LTCG = Sale price - (actual purchase price + inflation over the holding period)

The tax liability is then 20% of the LTCG computed above (irrespective of your income bracket).

Because of the indexation benefit, LTCG can be significantly lower than the actual gains, thus lowering your tax liability by a lot - in some cases even 0 when the gains are less than inflation!

What about TDS?
A TDS of 1% on high value transactions was recently introduced by the government to check tax evasion in real estate transactions but apart from that you need to compute your tax liability and pay the tax (or claim refund) on your own.

3. Stocks

Stocks (along with Equity Mutual Funds - more on that below) have the most lenient capital gains taxation.

If the holding period was less than 1 year, the gains will be marked as Short Term Capital Gains (STCG). STCG for stocks will be taxed at 15% flat (irrespective of your income tax level). That is even if you are in the 30% tax bracket, short-term profits booked from stocks will be taxed at only 15%.

Remember capital gains tax arises only when you sell your asset (stocks in this case). So if you are just holding your stocks while they increase in price, there is no tax liability at the end of the year.

If the holding period was more than 1 year, the gains will be marked as Long Term Capital Gains (LTCG). Tax on LTCG for stocks is ZERO! Even if you sell a stock for a 10x higher price, if the holding period is more than a year, you wont have to pay ANY taxes on your gains.

No wonder most of the wealth of the richest people in the world has come from owning stock - higher growth and lower taxes!

4. Mutual Funds

Mutual Funds invest in various assets like stocks, bonds, gold etc. so their taxation depends on the type of Mutual Fund.

From a taxation perspective, there are only two kinds of Mutual Funds - Equity Mutual Funds and Non-Equity Mutual Funds.

Also note that tax liability is the same for resident Indians as well as NRIs.

Equity Mutual Funds

These are Mutual Funds that invest at least 65% of their money in stocks and stock derivatives. Examples are diversified equity funds, sectoral equity funds, balanced funds having more than 65% equity, arbitrage funds etc.

The taxation of Equity Funds is similar to stocks. Along with stocks they are the most leniently taxed investments.

If the holding period was less than 1 year, the gains from the sale of your equity Mutual Fund units will be marked as Short Term Capital Gains (STCG). STCG for Equity Mutual Funds will be taxed at 15% flat (irrespective of your income tax level). That is even if you are in the 30% tax bracket, short-term profits booked from Equity Mutual Funds will be taxed at only 15%.

Again, remember that capital gains tax arises only when you sell your asset (stocks in this case). So if you are just holding your Mutual Fund units while they increase in price, there is no tax liability at the end of the year.

If the holding period was more than 1 year, the gains will be marked as Long Term Capital Gains (LTCG). Similar to stocks, tax on LTCG for Equity Mutual Funds is ZERO!

So even if you make crores over your lifetime by investing in Equity Mutual Funds, you don't have to pay a single rupee in taxes as long as the holding period for each fund is greater than 1 year.

What about TDS?
For resident Indians, no TDS is deducted on the sale of Mutual Fund units, whether short-term or long-term.
Any (short-term) capital gains tax liability has be to paid by you on your own.

For NRIs, TDS at 15% will be deducted for redemption from equity mutual funds within 1 year (STCG) whereas no TDS will be deducted for sale of equity mutual fund units held for more than a year (LTCG).

Non-Equity Mutual Funds (Debt Funds etc)

These are Mutual Funds that invest less than 65% of their money in stocks and stock derivatives. Examples are pure debt funds of all types - liquid, short term etc, hybrid funds holding less than 65% equity, gold funds etc.

The taxation here is not as lenient as Equity Mutual Funds and is similar to real estate - still making it better than Fixed Deposits, especially in the long term.

If the holding period was less than 3 years, the gains will be marked as Short Term Capital Gains (STCG). STCG from Non-Equity Mutual Funds is clubbed with your total income and taxed at your income tax level.

If the holding period was more than 3 years, the gains will be marked as Long Term Capital Gains (LTCG). Like real estate, LTCG from Non-Equity Mutual Funds also qualifies for indexation benefit i.e. in order to compute your gains, instead of using your actual purchase price you can use a higher inflation-adjusted price.

So LTCG = Sale price - (actual purchase price + inflation over the holding period)

The tax liability is then 20% of the LTCG computed above (irrespective of your income bracket).

Because of the indexation benefit, LTCG can be significantly lower than the actual gains, thus lowering your tax liability by a lot - in some cases even 0 when the gains are less than inflation!

What about TDS?
For resident Indians, no TDS is deducted on the sale of Mutual Fund units, whether short-term or long-term.
Any (short-term) capital gains tax liability has be to paid by you on your own.

For NRIs, TDS at 30% will be deducted for redemption from non-equity mutual funds within 3 years (STCG) and in case of LTCG, TDS at 20% with indexation will be deducted for sale of debt mutual fund units held for more than 3 years.

Summary Table of Capital Gains Taxation

*Surcharge and cess extra for all taxes and TDS rates

**indexation means that the cost of purchase can be increased by inflation while calculating taxable gains. Because of this you end up paying tax on returns only over and above the rate of inflation i.e. if overall returns are 8% and inflation is 7% then tax applicable is 20% of (8%-7%) = 20% of 1% = 0.2%.

Debt Mutual Fund vs FD - Who wins on taxes?

Debt Mutual Funds are 10 times more tax efficient than Fixed Deposits while providing similar safety and returns because of indexation benefits.

In FD all gains are taxed at your current income tax level irrespective of how long the FD was kept for.
So if you are in the 30% tax bracket, a 5 year FD at 7% pa will attract a tax of 30% of 7% = 2.1%. So your after-tax returns will be 7%-2.1% = 4.9% only!

Same investment made in Short Term Debt Mutual Funds for 5 years will be eligible for indexation under Long Term Capital Gains.

If the inflation during those 5 years is 6%, your tax liability will only be 20% of (7%-6%) = 0.2% - one-tenth of that of FDs and your effective after-tax returns will be 7%-0.2% = 6.8% !

If inflation is 7% or more, then the taxes will be zero!

There are more reasons to prefer Short Term Debt Funds over FDs but this is one of the biggest.

Capital Losses

What if instead of capital gains, you have a capital loss while selling your property or mutual fund units?

Obviously you don't have to pay any taxes if you have not made any money, but there is more.

Short Term Capital Losses can be set-off against other Short Term and Long Term Capital Gains (and not against your ordinary income) i.e. a short term loss booked in stocks or equity Mutual Funds can be used to cancel out all or part of short term capital gains in Debt Funds.

Long Term Capital Losses can be set-off against other Long Term Capital Gains only. Note that since there is no LTCG tax on stocks and equity Mutual Funds, any long term loss in them is a dead loss and can not be set-off against any thing else.

Also, if you are not able to set off your entire capital loss in the same year, both Short Term and Long Term loss can be carried forward for 8 assessment years.

Quite considerate, right?

You can read more about setting off Capital Losses here.

Capital Gains Report

Okay, while all of this is important to lower our tax bill, it still is a lot to keep track of especially all the dates and durations etc.

And if you have invested in Mutual Funds via a SIP, then there are so many transactions, each one month apart. When you sell in one go, capital gains tax for each of those instalments needs to be computed separately as some of them might be short term while others might qualify for long term.

Fortunately for you, it is going to be a breeze. You can now download your Capital Gains Report for your investments on Goalwise from your dashboard under the Downloads > Reports section. In this report you will be able to see how much Short Term and Long Term Capital Gains you have realised for all your equity and debt funds separately. We have taken care of all the calculations regarding durations etc.

Note that the report contains only the capital gains and not your tax liability on those gains. The final tax liability will still need to be calculated by you as that depends on your exact income level for that year and other capital gains or losses that you might have incurred elsewhere which only you (or your CA) will know. But that should be a lot easier once you have the Capital Gains report.


TL;DR

Mutual Funds are probably the most tax efficient investment options out there for both equity and debt and being aware of the tax implications will let you earn more returns without taking any extra risk. :)

References:
ICICI Pru AMC Tax Reckoner 2017-28