Investments in Mutual funds earn investors profits in the form of dividends and capital appreciation. Let us 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 who collects money from investors and invests that money by buying various asset classes (like Shares, Bonds, and Securities) from multiple sectors based on its fund allocation plan. It is managed by a Fund Manager who charges a nominal fee for investing the funds and managing the same. Mutual fund units are traded at Net Asset Value (NAV), calculated using the following formula:
NAV = Total Asset – Total Liability
No. of Units.
Types of Mutual Funds
Mutual funds are broadly categorized as below:
1) Equity Mutual Funds:
These funds predominantly invest in listed equity shares. As these 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
There are two categories of capital assets, depending upon the type and holding period of mutual fund units:
- Short-term capital assets: In the case of units of equity-oriented mutual funds (as defined u/s 112A of the Act), the period of holding to be considered is 12 months or less. The resulting capital gains (or loss) will be considered short-term capital gains
In the case of units of any other mutual fund, the period of holding to be considered for categorization as a short-term capital asset is 36 months or less.
- Long-term capital assets: Where the period of holding exceeds the time limits specified above, the underlying units qualify as long-term capital assets, and capital gains are categorized as long-term capital gains.
What is capital gains on Mutual Fund and how it is computed:
Capital gains refers to income/ profit earned from the sale of Mutual Fund Units. It 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 Mutual Funds
It is one of the important criteria for the taxability of MF. Holding period means the number of days the investment was held by the investor, i.e., the difference between the sale date and Purchase date.
In the case of Equity Oriented MF, if the investment is held for less than equal to 12 months, at the time of sale of such investment the gains earned would be called short-term capital gains. For investment held for more than 12 months, it becomes a long-term capital gain.
Similarly, in the case of Debt Oriented MF, if the investment is held for less than equal to 36 months, at the time of sale of such investment, the gains earned would be called short-term capital gains. For investment held for more than 36 months, it becomes a long-term capital gain.
How the Short-term Gains on Mutual funds are taxed in India
1. The Taxability of short-term capital gains on mutual funds depends on the category of Mutual fund.
2. In the case of the equity-oriented mutual fund, tax at the rate of 15% is levied on Short term capital gains.
3. If it is debt oriented mutual fund transaction, the tax will be charged based on the normal tax rate applicable to the assessee/investor. For instance, in the case of individuals, it will be taxed at normal tax slab rates.
To understand in detail the Short term capital gains on Mutual funds, let’s take an example:
|Mr. A invests Rs 50 Lakh in a particular Mutual Fund|
|Amount of Investment||Rs 50,00,000|
|Net Asset Value (NAV) as on date of purchase||Rs 500|
|Number of Units Purchased = 50,00,000 500||1,000 Units|
|Mr. A sold 600 units. (Partial sale of units are allowed under Mutual fund)|
|Net Asset Value (NAV) as on date of sale||Rs 650|
|Sale consideration = Rs 650/unit * 600 units||Rs 39,00,000|
|Cost of Acquisition = Rs 500/unit * 600 units||Rs (30,00,000)|
|capital gains =Sale Consideration-Cost of Acquisition||Rs. 9,00,000|
Continuing with the example already mentioned above wherein we have already computed capital gains of INR 9,00,000, below is the taxability.
|Type of MF||Equity Oriented MF||Debt MF|
|As per IT Act, holding period condition for capital gains to become short term||Less than equal to 12 months||Less than equal to 36 months|
|Date of Purchase||01-Oct-2021||01-Oct-2020|
|Date of Sale||25-July-2022||03-Feb-2023|
|Holding period||Less than 12 months||Less than 36 months|
|Taxable Amount (STCG)||9,00,000||9,00,000|
|Tax rate||Flat 15%||Normal tax rate applicable for the assessee.|
*Note: If the hybrid mutual fund is an ‘equity-oriented fund’ say, it has more than or equal to 65% investment in equity shares), then the STCG on its units will qualify for benefit under Section 111A and provisions similar to equity oriented mutual fund would apply in such case.
If STT is not paid, (i.e., units are not sold through the stock exchange), provisions applicable to Debt Mutual fund investment as mentioned in the above table would apply.
When the investor/assessee invests in any mutual fund units which are held for not more than 12 months (and STT is paid), not more than 36 months (in case of STT not paid cases) then such gains would be treated as short term capital gains and will be taxed in the hands of investor/assessee as per the rate specified under Sec 111A of the I-T Act,1961.
Frequently Asked Questions.
1. Whether dividends earned on an investment in mutual funds taxable?
As per the amendments made through Finance Act 2020, dividends declared/ paid by mutual funds are taxable in the hands of investors at the income-tax rates applicable to them.
2. What is the tax benefit of having a short-term capital loss on the sale of Mutual fund units?
A short-term capital loss is allowed to be set off against both long and short-term gains. In case there are no gains in the year, the loss can be carried forward up to 8 assessment years.
3. How is the holding period determined in the case of SIPs (Systematic Investment Plans)?
At the time of the sale of mutual fund units, each SIP date will be treated as a date of purchase (individually) and gains will be calculated accordingly by allocating sale proceeds on a FIFO basis over the period to determine the holding period.
4. What are the types of expenses which can form part of the Cost of Acquisition / Sale consideration for computing capital gains?
Any direct cost incurred in connection with the transfer or sale of Mutual fund units (like Brokerage, Stamp duty, etc.) can be included in the cost of acquisition. Also, the same can be adjusted while computing the Net Sale consideration.
Vaibhav is Chartered Accountant by profession, having experience of 4+ years in banking & finance sector.
Since past one year associated with Wint Wealth as Credit Principal. Previously worked with Northern Arc Capital for 2 years in FI-Credit Team and AU Small Finance Bank for 1 year in LAP-Credit Team.