New tax structure of mutual funds

The Union Budget 2018 has changed taxation rules for equity-oriented mutual funds. Taxation of all other funds (debt funds, debt-oriented hybrid, gold, international, fund-of-funds) remains the same as before. Here’s a comprehensive reckoner on mutual fund taxation, applicable from April 1st,2018 onwards.

Defining capital gain and dividends

Just to recap, you make returns in mutual funds in two ways. The primary way is capital gain. Capital gains is the appreciation on your investment value which you realise at the time of redemption, i.e., sale value less investment cost. Remember that capital gains are realised gains – you need to actually redeem your investments in order to make a capital gain. Unrealised or book gains do not qualify as capital gains for tax purposes. Capital gains are divided into long-term capital gains and short-term capital gains. The definition for long term and short term depends on the type of fund you hold.

Equity and equity-oriented funds: All equity funds and hybrid funds with at least 65% exposure in equity instruments come under this taxation. That would include balanced and equity savings category which have major portions in equity. Long term is defined as a period of more than 1 year from the date of investment. Short-term is a period less than 1 year from the date of investment.

Debt and debt-oriented funds: This includes all debt funds and hybrid funds which don’t fall in the equity category. For this category, holding period less than 3 years from date of investment is considered short term and any period above this is long term.

Gold funds, international funds, fund-of-funds: Holding period less than 3 years from date of investment is considered short term and any period above this is long term.

The second way you make returns in mutual funds is through dividends, which are declared by each fund. Here are the taxation rules in a nutshell for both capital gains and dividend, depending on the type of fund.

Equity taxation rules

Taxation on equity funds has changed with the 2018 budget proposals. Short term capital gains (STCG) are taxed at 15%. This remains unchanged.

Long term capital gains (LTCG), which were exempt until now, will continue to be exempt upto Rs.100,000 of gains per financial year. Gains made over and above this will be taxed at 10%, irrespective of your tax bracket from April 1st, 2018. This is exclusive of Securities Transaction Tax (STT) of 0.001% that you pay on redemption. Cess of 4% is also applicable, taking the total tax rate to 10.4%.

For example, say your long-term capital gain from your equity funds in a financial year is Rs 110,000. As Rs 1 lakh is exempt, you will pay tax on Rs 10,000 only. At the 10.4% rate, your tax outgo is Rs 1,040. But if your gains was say Rs 90,000, then you will not have to pay tax. Remember that this Rs 1 lakh limit is for capital gains from all direct stock investments and equity funds, and not per fund or per stock.

For existing investments

To prevent a retrospective taxation on your existing investments, the rule exempts long-term capital gains made before 31st January 2018. Only the gains made from thereon will be taxed. Here is how this works:

In normal circumstances, gains from an investment is merely the difference between investment cost and redemption value. Investment cost is the cost at which you bought. For investments made before 1st Feb 2018, the investment cost to compute long term capital is the higher of the following values:  

Let us understand this with an example. Say you bought a fund on 1st December 2016 at an NAV of Rs 100, and its NAV of 31st January 2018 was Rs 120. You sold it on 1st May 2018. Referring to the table above, the investment cost works out as below under different instances of sale value.

The above calculation is applicable only for existing investments with long term capital gains. For new investments made from February 1st 2018, gains will simply be the final value at redemption less cost.

Dividends distributed by equity funds were tax-free in the hands of investors until now. From the next financial year, the same will be taxed at 10% (plus surcharge at 12% and cess at 4%). Dividend Distribution Tax (DDT) will be deducted by the AMC and the dividend you receive will be net of tax. Your NAV will therefore reduce by the dividend amount plus the tax.

This rule on long-term capital gains and dividend applies from 1st April 2018 onwards.

Tax on Debt

There are no changes in the way debt funds are taxed. All debt funds, debt-oriented funds, gold funds and international equity funds will come under this taxation.

Short term capital gains are taxed at your income tax slab. That is, if you’re in the 20% tax bracket, you pay 20% of your capital gains as tax. If you’re in the 10% tax bracket, you pay 10% tax on your capital gain. Long term capital gains are taxed at an uniform rate of 20% with indexation benefits. This benefit lets you pay tax only for the gains you have made after adjusting for inflation. Indexation is a method by which your cost is adjusted for inflation, thereby reducing your taxable gains.   

Dividends from debt funds were always taxed and will continued to be taxed at the same rate of 25% but with a change in cess of 3% to 4%. This amounts to a Dividend Distribution Tax (DDT) of 29.12% on debt funds. Similar to DDT from equity funds, the tax will be paid by the AMC and will be deducted from your NAV. Your NAV goes down to the extent of dividend plus the tax.

When do you pay the tax?

Dividend Distribution Tax  (DDT) is deducted at source, by the AMC, at the time of declaring dividend. You do not have to pay the tax yourself.  

Capital gains taxes are required to be paid at the time of redemption. This will include switches and STPs where units are redeemed from a fund. In case of Resident Indians, capital gain taxes have to be paid while filing returns for the year. For Non-Resident Indians, the applicable rates will be deducted at source – this goes for both equity and debt funds.