While making investments we have to decide many things such as whether to invest in equity or debt funds or whether to choose growth option or dividend option and a lot of us are not aware of the tax repercussions of these decisions. Thus, we should be informed about the corresponding tax laws not only after the investment is sold when we actually owe taxes on them but also at the time of making investments. This article discusses about the tax liability that you may incur on the earnings from your investments based on the type of fund you invest in, the time horizon and the dividend options which you select according to the prevailing tax laws in India.
Types of earnings we get from mutual fund investments and taxes we owe on them
1) Capital Gains
The biggest gains we get from mutual fund investments are capital gains. The capital gains that you make can be computed using the formula given below–
Capital Gains = Sales Value – Cost of Acquisition (Indexed if long term)
Taxation of capital gains of equity-oriented funds (funds that invest more than 65% in equity)
Long Term Capital Gain Tax Liability – If your period of holding is more than 1 year then you have long term capital gains (LTCG). According to section 10(38) of the Income Tax Act LTCG from equity shares and equity oriented mutual funds are exempt. This is because they are already chargeable to STT (Securities Transaction Tax) in the hands of the AMC in the case of mutual funds.
Short Term Capital Gain Liability – If your period of holding is 1 year or less then you have short term capital gains (STCG). STCG from equity oriented mutual funds is chargeable at the rate of 15%.
Taxation of capital gains of non equity-oriented funds (funds that invest 65% or less in equity- applicable for debt, money market funds)
Long Term Capital Gain Tax Liability – If your period of holding is more than 3 years then you have long term capital gains (LTCG). LTCG from non-equity oriented mutual funds is 20% with indexation. This means that Cost of Acquisition (COA) should be adjusted with the effect of inflation using the formula-
Indexed COA = COA × Cost Inflation Index for the year of sales
Cost Inflation Index for the year of purchase
The cost inflation index (CII) for all the financial years from 1981-82 to the current year is given below:
| Financial Year | CII | Financial Year | CII |
| 1981-82 | 100 | 2000-01 | 406 |
| 1982-83 | 109 | 2001-02 | 426 |
| 1983-84 | 116 | 2002-03 | 447 |
| 1984-85 | 125 | 2003-04 | 463 |
| 1985-86 | 133 | 2004-05 | 480 |
| 1986-87 | 140 | 2005-06 | 497 |
| 1987-88 | 150 | 2006-07 | 519 |
| 1988-89 | 161 | 2007-08 | 551 |
| 1989-90 | 172 | 2008-09 | 582 |
| 1990-91 | 182 | 2009-10 | 632 |
| 1991-92 | 199 | 2010-11 | 711 |
| 1992-93 | 223 | 2011-12 | 785 |
| 1993-94 | 244 | 2012-13 | 852 |
| 1994-95 | 259 | 2013-14 | 939 |
| 1995-96 | 281 | 2014-15 | 1024 |
| 1996-97 | 305 | 2015-16 | 1081 |
| 1997-98 | 331 | ||
| 1998-99 | 351 | ||
| 1999-00 | 389 |
Alternatively you can also get it from the following link of the official website of the income tax department –
http://www.incometaxindia.gov.in/Pages/utilities/Cost-Inflation-Index.aspx
Short Term Capital Gain Liability – If your period of holding is 3 years or less then you have short term capital gains (STCG). STCG from non-equity oriented mutual funds are chargeable as per investor’s income tax slab rate.
2) Dividends and Interest Incomes
Dividend paid to investors on equity oriented mutual funds is exempt from income tax in the hands of the investor. Dividend distribution tax (DDT) is also exempt for equity oriented mutual fund for the AMC.
For non-equity oriented schemes, any income (like interest, bonus etc) is exempt from tax in the hands of the investor. However the AMC has to pay DDT. As per the latest tax laws DDT is paid at 14.1625% for debt funds and fund of funds by the AMC (if individuals and HUF are the investors) and DDT is paid at 28.325% for money market funds by the AMC for all investors.
Tax implications of choosing growth, dividend payout or dividend reinvestment options
While filling the form you must have come across these options. Most mutual fund schemes give one or more of these options and NAV of the different options may differ even though the portfolio and other parameters are the same. Lets know the reason behind this and help us choose better which option is more suitable for us.
Growth Option – In this option the NAV keeps growing over time and benefits of compounding can be felt the most as the entire capital remains invested and there is no distribution in the form of dividends or any other income during the holding period. The only drawback to this option is that when you eventually sell your holdings, the dividend which was otherwise an exempt income would now become part of your capital gains. However you don’t have to worry about it you invest in equity oriented funds and your Long term capital gains are already exempt. Thus, this option is good as it increases the effect of compounding in the long term but is not as suitable where capital gain taxes are chargeable.
Dividend Payout Option – In this option the dividend is paid to investors as and when declared and is deducted from the NAV. So, if the NAV is Rs 23.5 and the dividend announced is 25%, (on the Face Value NAV of Rs 10) i.e. Rs 2.5, then in the dividend payout option the dividend of Rs 2.5 per unit would be deducted from the NAV of Rs 23.5 resulting in the NAV of Rs Rs 21 and paying the dividend in cash to the investor. The advantage of this option is that we get tax free regular income however it does result in capital diversion as we keep on taking out the dividend amount.
Dividend Reinvestment Option – In this option the dividend declared is not paid to the investor. The units equivalent to the total amount of dividend a particular investor is entitled to get are issued to that investor at the NAV on the record date. For example a particular investor has 1,000 units of the fund. His total dividend is 2,500 at the rate of Rs 2.5 per unit. The NAV being Rs 23.5, he’ll get (2,500÷23.5) i.e. 106.38 more units automatically reinvested into the fund making his total holdings 1,106.38 units. This option is equivalent to getting dividend payout and reinvesting them yourself into the fund with the exception that entry load charge if any is not applicable under reinvestment option on the new units. This option can be disadvantageous when markets are not doing well and you don’t want to buy new units at that time.
How to calculate cost of acquisition for tax for SIP’s or when purchases have been made at different intervals of time?
Often when we opt for SIP (Systematic Investment Plan – to know more about them read the detailed article about SIP’s in the value investing section of this blog) or opt for dividend reinvestment option and get our dividend reinvested at a different NAV or when our investments are made at different NAV’s on different occasions then the calculation of cost of acquisition as per income tax laws becomes a little complex. Below, this concept is explained with the help of a hypothetical example.
Say, on 1st April you purchased 500 units @ NAV of Rs 25 per unit. On 23rd May you further purchased 300 units @ NAV of Rs 27 per unit. On 24th June you sold 700 units @ NAV of Rs 30. Since FIFO (First In First Out) is used according to the Income Tax Act your cost of acquisition for these 700 units is calculated as follows:
First 500 units cost Rs 25 = Rs 12,500
Next 200 units cost Rs 27 = Rs 5,400
Thus total COA = 17,900
Capital Gains = (700 × 30) – 17,900 = Rs 3,100
Cost of your remaining holdings of 100 units @ NAV Rs 27 is Rs 2,700.
Note : The tax rates mentioned in this article have been updated for PY 2016-2017
______
Liked this post :
Click here to subscribe to our premium newsletter for free and other updates