Want to Know How Hybrid Funds are Taxed? Read This

If you are looking at a tactical allocation or dynamic exposure to equity and debt (through a single fund), Hybrid Funds can be a meaningful choice. They offer you the stability of debt and aggression of equity, and the risk-adjusted performance depends on the sub-category of Hybrid Funds. The tax impact of investing in a Hybrid Fund depends on its sub-category.

The various subcategories of Hybrid Funds are:

- Aggressive Hybrid Fund

- Balanced Hybrid Fund

- Conservative Hybrid Fund

- Balanced Advantage Fund (also known as Dynamic Asset Allocation Fund)

- Multi-Asset Allocation Fund

- Equity Savings Fund

Before we go to the tax impact, you need to understand the characteristics of Hybrid Funds in detail:

Aggressive Hybrid Fund -- This one is mandated to invest 65%-80% of its assets in equity and the remaining 20%-35% of the corpus in debt & money market instruments. So, in other words, an Aggressive Hybrid Fund has an equity orientation. They are best suited if you have a high-risk appetite and an investment horizon of around 5 years.

Balanced Hybrid Fund -- As the name suggests the mandate here is to maintain a fair balance with an allocation of 40%-60% of the total assets in equity and 40%-60% in debt & money market instruments. No arbitrage is permitted. If you are a moderate-to-high risk-taker and wish to have almost an equal balance to both equity and debt, and have an investment horizon of 3 to 5 years, then a Hybrid Fund may be a suitable option.

Conservative Hybrid Fund -- This one has the mandate to invest predominantly, i.e. in the range of 75% to 90% of the total assets in debt securities, and the remainder in the range of 10% to 25% in debt instruments. Given this, it is also called a debt-oriented hybrid fund. If you have a lower risk appetite and an investment horizon of less than 3 years, such a scheme may be a suitable choice.

Balanced Advantage Fund/Dynamic Asset Allocation Fund -- Such a fund manages its allocation to equity and debt dynamically (depending on the market conditions and opportunities and threats playing out for the respective asset class); there is no fixed range for asset allocation. That said, going by the on-ground experience, most Balanced Advantage Funds tend to maintain a minimum 65% exposure to equities to benefit from the favourable tax status, except in circumstances when the equity market is at a lifetime high and valuations look a bit stretched. A Balanced Advantage Fund may be considered if you have a moderate-to-high risk appetite and an investment horizon of around 3 to 5 years.

Multi-Asset Allocation Fund -- As the name suggests, this one invests mainly in three asset classes, namely equity, debt, and gold, with a minimum exposure of 10% in each. This offers you tactical diversification in all three asset classes that usually share a low positive correlation with one another. A Multi Asset Allocation Fund is a worthy choice to generate wealth over 3 years with exposure to all equity, debt, and gold by assuming moderate-to-high risk.

Equity Savings Fund -- This one is mandated to invest at least 65% of its assets in equities (across market capitalisations) and at least 10% in debt instruments (across credit profiles and maturities). Such a fund also takes advantage of arbitrage opportunities and deploys hedging strategies. Compared to an Aggressive Hybrid Fund (and other pure equity funds), an Equity Savings Fund is less volatile. That said, such type of Hybrid Fund is suitable if you have a high-risk appetite and an investment horizon of 3 to 5 years).

Now coming to the tax impact of investing in Hybrid Funds...

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How are Hybrid Funds taxed?

Well, the taxman has made it fairly easy for you. From a taxation perspective what matter is whether it is an equity-oriented or non-equity-oriented (i.e. debt oriented) Hybrid Fund.

Any mutual fund scheme that holds 65% of its assets in equity and equity-oriented assets is classified as an equity fund. If the Hybrid Fund you invested does not meet this criterion, it is classified as a non-equity scheme for tax treatment.

Thus, typically, Aggressive Hybrid Funds, Equity Savings Funds and Dynamic Asset Allocation Funds qualify as equity funds, and the rest are non-equity funds.

If you have opted for the Income Distribution cum Capital Withdrawal (IDCW) -- formerly known as the Dividend Options -- the income in the form of dividend will be taxable as 'Income from Other Sources' and taxed as per your income tax slab rate.

If the dividend amount is above Rs 5,000 dividend will be subject to Tax Deducted at Source (TDS) as per Section 194K @10% for resident individuals, but if the PAN is not provided then @20%.

In the case of an NRI (Non-Resident Indian), the TDS rate will be as per section 195 @ 20% tax plus the applicable surcharge and cess.

Speaking of capital gains, there can be two cases -- Short-Term Capital Gains (STCG) or Long-Term Capital Gains (LTCG).

Taxation of Equity-oriented Hybrid Fund

If the realised gains in any equity-oriented Hybrid Fund are made in less than 12 months of the holding period, called Short Term Capital Gains, they are taxed at a flat 15%.

However, if the holding period is 12 months or above in the case of an equity-oriented fund, called Long Term Capital Gains, the realised gains over Rs 1 lakh with be taxed @10%.

Taxation of Non-Equity Hybrid Fund

In the case of Non-equity Hybrid Funds, the STCG gains for holding less than 36 months get added to your Gross Total Income and taxed as per your applicable income-tax slab rate.

For a holding period of 36 months or more in the case of a non-equity Hybrid Fund, the LTCG tax is 20% with indexation.

Here's an example of how you should calculate LTCG tax in the case of a non-equity Hybrid Fund:

LTCG= Value realised on redemption - indexed cost of acquisition

Wherein, Indexed cost of acquisition= [(Cost of acquisition) × (Cost Inflation Index for the year of transfer)] /

(Cost Inflation Index for the year of the acquisition or for the Financial Year 2001-02, whichever is later)

Suppose you invested Rs 1,00,000 in a Conservative Hybrid Fund in FY16 at a NAV (Net Asset Value) of Rs 10 and were allotted 10,000 units.

Now if you redeem all the units of the fund at a NAV of Rs 16 in the current fiscal your index cost of acquisition will be:

(1,00,000 * 331)/254 = Rs 1,30,315

Proceeds that you received on redemption would be Rs 16* 10,000 units = Rs 1,60,000 lakh.

In this case, your LTCG would be Rs 1,60,000 - Rs 1,30,315 = Rs 29,685. And your LTCG tax would be t Rs 5,937 (20% of Rs 29,685).

If you had invested the same amount in an Aggressive Hybrid Fund, your LTCGs wouldn't have been taxed at all since they are below Rs 1,00,000. For gains above Rs 1,00,000, you would pay LTCG tax at 10% without indexation.

Should you invest in hybrid funds now?

Since equity markets have been hovering near their lifetime highs in India and we are at least half-way-through the current monetary tightening cycle, choosing a Hybrid Fund would be wise at this juncture.

Although taxation can affect your total returns substantially, you should never choose a fund to opt for favourable tax treatment. Always make a thoughtful choice considering your risk profile, broader investment objective, the financial goal/s you are addressing, and the time in hand to achieve those goal/s.

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Warm Regards,
Rounaq Neroy
Editor, Daily Wealth Letter