Long Term Capital Gain on Mutual Funds – Tax Exemptions and Calculations
Investments in Mutual funds earn investors concerned profits in the form of dividends and capital appreciation. In this article, we will understand more about mutual funds investment and the taxability of capital appreciation earned from such investments under the Income-tax Act,1961 (I-T Act) and Income-tax Rules, 1962 (‘Rules’).
What is Mutual Fund Investment and how does this work?
A Mutual Fund is like a trust, which collects money from investors and invests that money in financial assets (such as shares, bonds, and other securities) across different sectors based on its fund allocation plan. It is managed by a Fund Manager who/ which charges a fee for investing the funds and managing the same. Mutual fund units are traded at Net Asset Value (NAV) on stock exchanges, calculated using the following formula:
NAV = Total Asset – Total Liability
No. of Units.
Types of Mutual Funds
Mutual funds are broadly categorised as below:
1) Equity Mutual Funds:
These funds predominantly invest in listed equity shares. As the underlying investment in such funds (viz., the equity shares) are traded on a stock exchange, investment in these funds carries a higher risk. Consequently, this fund generally has a higher yield/return compared to other types of Mutual Funds.
2) Debt Mutual Funds:
These funds predominantly invest in fixed-income carrying securities like Government bonds, corporate bonds, commercial papers, etc. Since these are less volatile, they provide a stable return to investors. Their prices generally move in line with the inflation rate.
3) Hybrid Mutual Fund:
These funds invest in both equities as well as fixed income securities. Such funds are ideal for investors who prefer to have a balanced investment, having a mix of both fixed-income returns (like Debt funds) and value appreciation (like Equity Funds). Since these funds have an equity element, they are generally more volatile compared to Debt Funds.
Type of capital assets
The definition of ‘capital asset’ is wide enough to include most movable and immovable assets/ properties. For the purpose of taxation of shares, capital gains are classified into two categories of capital assets, depending upon the holding period of shares:
- Short-term capital assets: In the case of shares (whether equity or preference), which are listed in a recognised stock exchange in India, the period of holding to be considered is 12 months or less for capital gains to qualify as short-term capital gains.
On the other hand, in the case of unlisted shares (whether equity or preference), the period of holding to be considered for categorisation as a short-term capital asset is 24 months or less.
- Long-term capital assets: In relation to listed shares (whether equity or preference), the period of holding is more than 12 months for the resulting capital gains (or loss) to be considered long-term capital gains.
On the other hand, in the case of unlisted shares (whether equity or preference), the period of holding to be considered for categorisation as a long-term capital asset is 24 months.
Capital gains on sale of units of Mutual Fund
Capital gains (i.e. income/ profit earned) from the sale of Mutual Fund units is computed by reducing the cost of acquisition from the sale proceeds.
Sale Consideration is Net Proceeds generated from the sale of Mutual Fund Units and Cost of Acquisitions is the price paid to acquire Mutual Fund Units.
The formula for computing capital gains on units of mutual funds is as follows:
Capital gains = Sale Consideration – Cost of Acquisition
Taxability of incomes from Mutual Funds
- On sale of units of mutual fund
Section 112A of I-T Act 1961 defines the long-term capital gain on mutual funds.
|Type of Mutual fund||Taxability|
|Equity-oriented mutual fund||If the mutual fund held for more than 1 year then it is taxed at the rate of 10% if gain exceed INR 1 Lakh in a financial year|
|Non equity-oriented mutual fund (where more than 35% but less than 65% of the total proceeds are invested in equity shares of domestic companies) acquired on or after 1.4.2023||20% with indexation benefit (Indexation adjust the purchase price of the asset for inflation, which reduce the taxable gain)|
|Non equity-oriented mutual fund (where up to 35% of the total proceeds are invested in equity shares of domestic companies) acquired on or after 1.4.2023||Taxable as short-term capital gains without any indexation benefit and as per applicable slab rate|
- Taxability for dividend received on mutual fund units
Vide Finance Act 2020, dividend has been made taxable in the hands of the shareholder at the rate of tax applicable to such shareholder. For instance, in case of a resident individual, the dividend received will be taxable as income from other sources at the applicable slab rate.
- Taxability for Systematic Investment Plan (SIP)
SIP is an investment method that allows investors to invest small amounts of money periodically in mutual fund schemes that can be done either weekly, monthly, quarterly,bi-annaully or annually giving investors the flexibility to choose the investment timeline that suits them.
In SIP . investors purchase a certain number of mutual fund units in each instalment and redemption is on the basis of first-in-first out basis.
Long-term capital gain
For example: Mr Ram invests in an equity fund through a SIP for one year and decides to redeem the entire investment after 13 months, the units purchased first through the SIP are held for the long term and long term capital gain applies to these units. If the long-term capital gains are less than ₹ 1,00,000 then no tax is levied.
Grandfathering clause for taxability on mutual fund
The government of India has introduced a grandfathering clause which means that long-term capital gain tax is not applicable on gains made on mutual funds purchased before January 31,2018, and sold after April 1,2018. The government has done so to protect the investors from the sudden impact of the introduction of LTCG tax.
- LTCG tax on equity mutual funds is lower than the tax on short-term capital gains (STCG) at a rate of 15%, making long-term investments more tax-efficient.
- The LTCG tax is applicable only when the gains exceed Rs 1 lakh, which provides relief to small investors.
- The introduction of the grandfathering clause has provided a tax relief to investors who have made investments in mutual funds before January 31, 2018.
- The indexation benefit helps investors reduce their tax liability, especially in the case of certain debt mutual funds, where the tax on LTCG can be as high as 20% without indexation benefit.
It’s important to note that mutual funds are subject to market risks, and investors should consider their investment objectives, risk tolerance, and financial goals before investing.
It’s also crucial to keep track of any changes in tax rates and rules applicable to mutual fund investments.
Frequently Asked Questions (FAQs)
- Are there any other taxes applicable to mutual funds?
Yes, investors may also have to pay Securities Transaction Tax (STT) while buying or selling mutual funds on the stock exchange. Additionally, there may be other taxes such as Goods and Services Tax (GST) or other levies, depending on the type of mutual fund and the investment amount.
- What is the tax implication for non-resident Indians (NRIs) on LTCG tax for mutual funds?
NRIs are subject to LTCG tax on mutual funds similar to resident Indians. The tax rate for NRIs is 10% without indexation benefit or 20% with indexation benefit, depending on the type of mutual fund and the investment period.
- Can an investor offset their capital gains from one mutual fund with losses from another mutual fund?
Investors can offset their capital gains from one mutual fund with losses from another mutual fund in the same financial year. This is called capital gains tax harvesting and can be used to minimize the overall tax liability.
- Are there any tax benefits of investing in Equity Linked Saving Schemes (ELSS) mutual funds?
ELSS mutual funds offer tax benefits under Section 80C of the Income Tax Act, which allows investors to claim a deduction of up to Rs 1.5 lakh from their taxable income. The investment period for ELSS mutual funds is three years, and any gains made after three years are tax-free.