3-Tiered Taxation of Mutual Funds: Here's All You Need to Know

Apr 21, 2023 / Reading Time: Approx. 10 mins

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Mutual Funds help you in wealth creation and work towards achieving your financial goals; this makes them one of the most buzzing investment options. One of the biggest advantages of mutual funds is that they are tax-efficient investment vehicles. You benefit from expert money management and tax-efficient returns when you invest in mutual funds.

You might, however, be making the wrong choice in mutual funds if you don't account for taxes. If you are a mutual fund investor or are planning to invest in mutual funds, it is imperative for you to understand the tax implications on your capital gains from mutual funds. Notably, the returns you generate on your mutual fund investments are classified as 'capital gains' and will be taxable as per the holding period.

 

Mutual Funds have turned out to be one of the most sought investment options for discerning investors keen to grow their wealth. Taxes are impossible to avoid; therefore, it is advisable to understand how they affect mutual funds and the advantages of prudent tax planning.

Additionally, by comprehending how mutual funds are taxed, you may organise your investments to lower your overall tax burden. Moreover, you can benefit from a number of tax deductions provided by the Income-tax Act of 1961, such as Section 80C. As a result, you should be well-versed on the tax regulations governing mutual funds before investing. This article will walk you through all the elements of mutual funds taxation.

What are the factors that determine the taxation of mutual funds?

Taxation on mutual funds can be explained further by pointing out the factors influencing it. Here are the essential factors that are broken down into smaller bits, making it easier to understand.

  • Type of Mutual Fund

    For taxation purpose, mutual funds are classified into 2 groups: Equity-oriented Mutual Funds and Debt-oriented Mutual Funds. The tax treatment on equity mutual fund schemes differs from that of debt mutual fund schemes.

  • Capital Gains 

    Capital Gains are profits made when investors sell their capital assets for more money than the initial investment amount. If any equity mutual fund scheme is held by an individual for more than 12 months or over a period of 1 year, it is regarded as a long-term capital gain, and for less than 12 months, it is considered a short-term capital gain. Similarly, for a debt-oriented mutual fund scheme, if held for over 36 months, the gains are regarded as long-term, and for less than 36 months, they are considered short-term gains.

  • Dividend

    The taxation on mutual funds also depends on the type of gains generated out of the funds. Capital gains are when you sell a capital asset at a profit. On the other hand, dividends are the share of profits distributed by the fund manager out of the fund's positive returns. While capital gains are received after the redemption of mutual fund units, investors need not redeem their assets to receive a dividend.

  • Holding Period of Investor

    The holding period is the time between the date of purchase and sale of mutual fund units. The holding period influences the tax rate payable on your capital gains. The higher your holding period, the lesser tax you are liable to pay. India's income tax regulations encourage a longer holding period, which is why holding your investment for longer reduces your tax liability.

However, there has been a change in the taxation of mutual funds for debt-oriented mutual funds which was announced in the Finance Bill 2023.

3-Tiered Taxation of Mutual Funds: Here's All You Need to Know
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As per the latest update in the tax implication of mutual funds, no indexation benefit will be provided while calculating long-term capital gains on a specified mutual fund (i.e., a mutual fund which invests less than 35% of its proceeds in the equity shares of domestic companies). Debt mutual funds will now be taxed as per the applicable income slab rates.

[Read: Indexation Benefits on Debt Mutual Funds Removed: A Strategy to Manage Your Debt Allocation]

At the beginning of the new financial year 2023-24, some mutual fund schemes' tax implication was changed. The holding duration and type of mutual fund affect the tax rate on capital gains for mutual funds. Taxation of mutual funds based on capital gains is as mentioned below:

Mutual Fund Type Short-term Gains Long-term Gains
Equity-oriented Mutual Fund Holding Period Up to 12 months Over 12 months or 1 year
Tax Ratev 15% Any gains above Rs 1 lac will be taxed at 10%
Debt-oriented Mutual Fund Holding Period Up to 36 months Over 36 months or 3 years
Tax Rate Investor's income tax slab rate Old tax rate - 20% with indexation benefit

New tax rate - Investor's income tax slab rate (w.e.f 01/04/2023)
 

There is significant confusion regarding the tax treatment as a result of the change in taxation standards for mutual funds. Previously, there were only two categories that existed; if a mutual fund scheme did not attract equity-like taxation, it automatically attracted the second type of taxation, which is for the debt category. Having said that, now there are three distinct categories based on how taxes on mutual funds are handled, which is known as a Three-tiered tax structure.

There are two elements that need to be taken into account when taxation is determined. One is the prerequisite that must be met, and the other is the rate that is relevant to the particular funds that meet the requirements in a given category.

1. If equity exposure is more than 65% (Equity-oriented Schemes)

Mutual Funds that invest primarily in domestic equity are subject to the first tier of taxation. These are all the mutual fund schemes that have portfolio exposure to domestic companies of at least 65% on average. This means that any fund will be categorised as an equity-oriented fund if it has an average annual exposure to equity of 65% or more. However, there may be brief intervals during the year when the exposure to equities falls below this level. In light of this, equity-oriented mutual funds will be subject to the tax rates shown in the above table.

2. If equity exposure is less than 35% (Debt-oriented Funds)

The second category, which includes funds with an annual average domestic equity holding of less than 35%, is subject to separate tax treatment. The mutual fund categories with low exposure to domestic equity of < 35% includes all the debt-oriented funds, gold mutual funds, and even pure international funds. Some hybrid funds will also fall into this category.

However, as per the new tax rule mentioned in the Finance Bill 2023, no matter how long the holding period is, there will be no indexation benefit on this type of mutual fund scheme. It means that the gains from such investments will be taxed at an individual's income tax slab rate, as mentioned in the table.

3. If equity exposure falls between >35% and <65%

Now under this classification, funds with an annual equity exposure between 35% and 65% will fall under a different category known as hybrid funds. In this case, the holding period will be 3 years for the categorisation of either a short-term capital gain or a long-term capital gain (i.e., STCG <3 years and LTCG >3 years). Short-term capital gains are subject to taxation at the individual's marginal tax rate, which is determined by their income. Mutual funds falling under this third group, however, are eligible for the indexation benefit and will be subject to a 20% tax rate under the amendment in Finance Bill 2023 pertaining to debt mutual funds.

As a result, if there is a long-term capital gain, the rate of taxation will be 20% with indexation benefits, meaning the gains are adjusted for inflation and then taxed. The schemes include some moderate and aggressive hybrid funds that will enjoy the older tax rule of debt mutual funds. Investors seeking to take advantage of the older tax implications may think about participating in a mutual fund scheme with equity exposure between 35% and 65%, depending on their suitability for factors such as risk tolerance, investment horizon and financial goals.

To conclude...

The taxation of mutual funds isn't as complicated as one might think. Mutual funds are enticing investments that produce significant returns to help you reach your financial goals. However, you need to be ensured before investing your hard-earned money. The type of funds, the returns, and the eventual tax liability should be very clear to you before you actually invest.

If you are planning to invest in tax-efficient mutual funds, you may consider Equity Linked Savings Scheme (ELSS). Tax saving is an integral part of one's wealth creation journey. ELSS is one of the worthy avenues for tax saving. PersonalFN's Definitive Guide, '3 Best ELSS to Invest in 2023', offers a list of carefully selected ELSS to invest in 2023.

This Guide will show you how to pick a worthy ELSS, a tax-saving mutual fund, that could potentially maximise your wealth and act as an effective tool for tax planning. If you are looking to invest in ELSS, then Subscribe now! To PersonalFN's Definitive Guide '3 Best ELSS to Invest in 2023'.

 

MITALI DHOKE is a Research Analyst at PersonalFN. She is an MBA (Finance) and a post-graduate in commerce (M. Com). She focuses primarily on covering articles around mutual funds including NFOs, financial planning and fixed-income products. Mitali holds an overall experience of 4 years in the financial services industry.

She also actively contributes towards content creation for PersonalFN’s social media platforms in the endeavour to educate investors and enhance their financial knowledge.


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