Tax implications of investing in mutual funds

A primer on tax you pay on your mutual fund gains

What is the tax on capital gains?

When you sell an asset and make a profit on it, it is known as capital gains. This is applicable to any asset -- property, stocks, bonds, mutual funds, art, gold, and so on and so forth. In other words, when you sell your mutual fund units, you incur a capital gains tax.

Capital gains is further split into long term and short term. And the tax implication differs for equity and debt funds.

Equity funds

An equity oriented mutual fund is one where a minimum 65 per cent of the investible corpus is invested in domestic equity.

So gold exchange traded funds, or Gold ETFs, are not treated as equity funds for taxation.

Even international funds are not considered as equity funds in the case of taxation even though they invest in equity. The criteria to qualify for an equity fund is not just investments in stocks but stocks listed in India.

In the case of hybrid or balanced funds, if at least 65 per cent of the assets are invested in domestic equity, they qualify as equity-oriented funds.

If you sell an equity mutual fund after holding it for a period of 12 months, then it qualifies for long-term capital gains. As of now, long-term capital gains on equity funds is nil. So you pay no tax.

If you sell your equity mutual fund before this period, then it qualifies for short-term capital gains, which is 15 per cent.

Another feature of an equity fund is that dividends are not taxed. The dividend is tax free in the hands of the unit holder. Neither does the fund house have to pay any dividend distribution tax.

Debt funds

The non-equity funds qualify as debt funds for the purpose of taxation. So this would include all types of debt funds, international funds, monthly income plans, or MIPs, and Gold ETFs.

Short-term capital gains would be levied if the holding period is less than 3 years. Short-term capital gains are added to the income and taxed as per the individual's income tax slab. From a tax perspective, it is obvious that debt funds no longer offer tax advantages over fixed deposits if the holding period is less than three years.

If you sell the asset after holding it for a period of 36 months, or 3 years, it qualifies as long-term capital gains. This is 20 per cent with indexation.

Indexation is the process that takes into account inflation from the time you bought the asset to the time you sell it. The way it works is that it allows you to inflate the purchase price of the asset (in this case the mutual fund units) to take into account the impact of inflation. The end result is that you get the benefit of lowering your tax liability.

Dividends received in the case of a debt fund unit holder are exempt from tax. However, the fund house has to pay a dividend distribution tax, or DDT, before distributing this income to its investors. The DDT is deducted by the asset management company prior to the disbursal of dividends. So, no tax on dividends is payable in the hands of the investor.

All the tax rates mentioned above do not include surcharge and education cess.

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