Mutual Funds can be considered as a pool of investment which is used to purchase securities in the market. These investments are made by multiple entities in the market, such as individuals, companies, financial institutions, etc. Mutual Funds can be used to purchase securities of all kinds, such as equity funds, balanced funds, and debt funds.
In most cases, an individual’s investments are managed by a fund manager, however, if someone is an expert in market conditions and is aware of tentative market fluctuations they can choose to do the investments themselves, thus saving on fund manager’s fees.
Investment in Mutual Fund opens up multiple income opportunities in the form of dividends and capital gains. Dividends are disbursed periodically to investors on a pro-rata basis. Capital gains occur when an entity takes advantage of capital appreciation of security over time by selling or transferring it. Long-term capital gain tax on Mutual Funds and short-term capital gain tax as well varies across different investment options.
Capital Gains on Mutual Funds
Capital gains occur when individual benefits from the capital appreciation of securities by selling or transferring them at the opportune period. A fund manager predicts that opportune moment when selling a fund would reap the most profits or gains.
These securities can be classified into two types depending on their holding period – long-term capital assets and short term capital assets. Capital gains are differentiated based on the kind of asset sold or transferred.
If listed equity funds and equity-oriented balanced funds are held for a period less than 12 months or 1 year, then they would be considered short-term capital assets, and if they are held for a period longer than that, they would be regarded as long-term capital assets.
In case of unlisted equity funds, debt funds and debt-oriented balanced funds if the holding period is longer than 3 years or 36 months, they are classified as long-term capital assets. If the period is less than 3 years, then it is considered short-term capital assets.
The following table demonstrates the classification–
|Types of funds||Long-term asset||Short-term asset|
|Listed equity funds and equity-oriented hybrid funds||More than 12 months||Less than 12 months|
|Unlisted equity funds||More than 36 months||Less than 36 months|
|Debt funds and debt-oriented balanced funds||More than 36 months||Less than 36 months|
LTCG tax on Mutual Funds is comparatively lower than short-term capital gains tax on Mutual Funds. This taxation system has been adopted to encourage investors to keep their money invested for a longer period.
Long-term Capital Gain Tax on Mutual Funds
Individuals are taxed differently depending on the kind of funds they hold. The long-term capital gains tax implications across different Mutual Funds are –
- Equity funds – These Mutual Funds are used to purchase equity shares of different companies. There are two kinds of equity funds in the market – tax-saving equity funds and non-tax saving equity funds.
Equity-Linked Savings Scheme or ELSS is the tax-saving equity fund. In the case of ELSS, there is a lock-in period of 3 years before which an individual cannot sell or transfer his/her funds. Therefore these funds are bound to attract long-term capital gain on tax.
There is no such lock-in period in case of non-tax saving equity funds, and therefore they can attract both LTCG tax and STCG tax depending on the holding period. All kinds of equity funds trigger a tax of 10% above Rs. 1 Lakh without the benefit of indexation after 12 months. Investors can avail exemption up to the capital gain amount of Rs. 1 Lakh.
For example, Mr Anil invested Rs. 3 Lakh in an equity fund on 1.2.17 and sold the same on 31.3.2019 for Rs. 4.5 Lakh. His capital gain in that matter would be Rs. 1.5 Lakh. In that case, a 10% tax would be levied on Rs. 50,000 exceeding the Rs. 1 Lakh margin.
- Equity oriented hybrid Funds – These Mutual Funds are used to purchase both equity funds and debt funds. However, in that composition, more than 65% of investment should be toward equity shares or equity-oriented shares. Therefore, these funds attract a similar long-term capital gain tax as equity funds.
- Debt Funds –These Mutual Funds are used to purchase debt instruments from the market. LTCG tax rate on Mutual Funds is 20% after indexation. Indexation is done through the Cost Inflation Index (CII) which involves factoring in inflation in the cost of acquisition. It helps in lessening the capital gain amount.
The formula for calculating indexed cost of acquisition = (Actual cost of acquisition*Current year’s index)/ Base year’s index.
For example, Mr Bose invests Rs. 2 Lakh in debt funds on 30.4.15 and transfers the same on 1.2.19 for Rs. 3.5 Lakh. Cost Inflation Index in AY 2015-16 is 254, and in AY 2018-19 it is 280. The indexed cost of acquisition would be = (200000 x 280)/254 or Rs. 2,20,472 and long-term capital gain would be Rs. (350000 – 220472) or Rs. 1,29,528.
- Debt-oriented balanced funds – In these kinds of funds, more than 60% of funds are reinvested towards debt instruments. These funds attract a tax rate of 20% after indexation.
- Unlisted equity funds – Long-term capital gains on unlisted equity funds are taxed at 20% (surcharge and cess as applicable) with the benefit of indexation.
Table demonstrating long-term capital gain tax on Mutual Funds
|Particulars||Applicable tax rate|
|Equity funds||10% tax rate on the amount exceeding Rs. 1 Lakh without indexation|
|Equity-oriented hybrid funds||10% tax rate on the amount exceeding Rs. 1 Lakh without indexation|
|Debt funds and debt-oriented funds||20% tax rate with the benefit of indexation|
|Unlisted equity funds||20% tax rate with the benefit of indexation|
Different Forms of Mutual Fund Investment
There are primarily two ways in which an entity can decide to invest in Mutual Funds for the convenience of the investor. These are – Systematic Investment Plan (SIP) and Lump-sum Investment. In the case of SIP, an entity can decide to invest in Mutual Funds periodically rather than at once.
Tax implication on Systematic Investment Plan
The dynamics for long-term capital gain tax on Mutual Funds slightly different. In the case of SIP, every instalment is seen as a separate investment. Therefore, tax is levied separately on the gains from each instalment. The tax rate it triggers depends on the kind of fund invested in.
For instance, Mr C decides to begin SIP for Rs. 12000 quarterly in an equity fund on 1.2.18 for 12 months. He earns Rs. 2000 as capital gains from every SIP. After 12 months he decides to redeem the entire corpus of Rs 56000 (Rs. 48000 as the investment and Rs 8000 as gains).
However, short-term capital gain tax will be levied only on Rs. 6000 which are gains from later instalments and no long term capital gain tax on mutual funds will be levied from the first instalment as it is below Rs. 1 Lakh.
Securities Transaction Tax
Another kind of tax which is levied on Mutual Funds is Securities Transaction Tax (STT). It does not depend on the holding period. It is levied on securities upon purchase and sale. Investment in debt funds does not incur any form of STT.
Tax situation on long-term capital gains
Before 2018, long-term capital gain tax on Mutual Funds for equity funds and equity-oriented hybrid funds did not exist under Section 10 (38). However, after the introduction of Finance Bill 2018, the Section 10 (38) was lifted, and a parallel Section 112A was introduced which postulated a 10% tax rate on long-term capital gains above Rs. 1 Lakh and a grandfathering provision as well.
However, it posed difficulty for many entities, including foreign investors and discouraging investment sentiment in the stock market. Therefore, the Ministry of Finance is considering lifting long-term capital gains tax on Mutual Funds for funds which have been held for more than 3 years.
This measure might encourage investors to do not sway from their investment within the specified period.
Mutual Funds are considered one of the safest options for investments among market-linked financial instruments compared to other such instruments as it assures of periodical returns to a certain extent. Also, they offer higher returns compared to fixed-income instruments.
Primary advantages of Mutual Funds are they offer economies of scale, flexible investment options and higher liquidity compared to direct investments.