Decoding tax on mutual funds

Making gains on mutual funds? An analysis of the various tax scenarios

Retail investors in India have taken the mutual fund route to investing in a big way over the past few years. Sooner or later, many of them are likely to sell some or all of their fund units and will have to deal with the tax on their transactions. In this context, the amendments made in Budget 2018 are significant.

Big change

Capital gain is the selling price of an asset minus its cost of acquisition. Until March 2018, long-term capital gains (LTCG) on listed equity shares and equity mutual funds were exempt from tax. So, if you sold these shares and equity mutual fund units after holding them for more than 12 months from the date of acquisition, the gains were considered long term and no tax was levied. Gains on equity shares and equity mutual funds held for 12 months or less (short-term capital gains) were taxed at a concessional rate of 15 per cent.

But from April 2018, the tax treatment has changed. From fiscal 2018-19, LTCG arising from transfer of such equity shares and equity mutual funds exceeding ₹1 lakh a year will be taxed at 10 per cent. Short-term gains continue to be taxed at 15 per cent.

Investors have been given another concession — the ‘grandfathering’ clause on LTCG — to soften the tax blow. On sales from April 1, 2018, LTCG on listed equity shares and equity mutual funds up to January 31, 2018 will be grandfathered, that is, they will continue to be exempt from tax, and only LTCG made after January 31, 2018 will be taxed.

This concession is enabled by the formula to determine the cost of acquisition — Higher of a) actual cost b) lower of i) fair market value on January 31, 2018 ii) selling price. The fair market value on January 31, 2018 is the highest intra-day traded price for listed equity shares, and the net asset value (NAV) of mutual funds on that day.

Once the LTCG is determined, gains in excess of Rs 1 lakh a year will be taxed at 10 per cent. Surcharge on tax, depending on the income level, and cess at 4 per cent (3 per cent earlier) on tax-plus-surcharge will also apply.

Indexation of cost of acquisition that factors inflation over the holding period of the investment, is not allowed in the case of LTCG tax on equity shares and equity mutual funds. The grandfathering benefit is available only on sale of equity shares and equity funds bought up to January 31, 2018. Long-term capital loss arising on sale of listed equity and equity mutual funds made on or after April 1, 2018 can be set off and carried forward for eight years as per the tax rules.

Another key change is the tax on dividends distributed by equity mutual funds at 10 per cent — including surcharge and cess, it works out to about 11.65 per cent. Earlier, such dividends were exempt from tax. This dividend distribution tax (DDT) will be paid by the mutual fund; the investor bears the cost indirectly through dip in NAV.

There was no change in Budget 2018 in the taxation of gains from non-equity mutual funds. So, if you sell these mutual fund units after holding them for more than 36 months, the gains are considered long-term and tax is levied at 20 per cent with indexation benefit. Gains on non-equity mutual funds held for 36 months or less (short-term capital gains) are taxed at the investor’s tax slab rate (5, 20 or 30 per cent). Surcharge, depending on the income level, and cess on tax-plus-surcharge will apply. Dividend distribution tax to be paid by mutual funds on non-equity schemes will continue at 25 per cent plus surcharge and cess — effectively 29.12 per cent.

Equity-oriented funds are those that invest above 65 per cent of their corpus in the equity shares of domestic Indian companies. This category includes equity funds across market capitalisations, equity linked savings schemes (ELSS), hybrid equity-oriented funds and arbitrage funds. Non-equity oriented funds include debt funds, gold funds, hybrid debt-oriented funds, international funds, and fund of funds. Against this backdrop, here’s how the tax game plays out in various situations of mutual fund sales from April 1, 2018.

Sale of lumpsum investments

The tax calculation on sale of a lumpsum mutual fund investment is fairly straight-forward.

Say, you bought 2,000 units of an equity fund in April 2015 at an NAV of ₹15, sold all of them in August 2018 at an NAV of ₹30, and the fair market value of the units as on January 31, 2018 was ₹25.

The gains on the units sold will be long term in nature, having been held for more than 12 months and will have the benefit of grandfathering of gains up to January 31, 2018. The LTCG will be ₹5 (30-25) per unit, and the tax rate will be 10 per cent.

Now, if these units were of a debt mutual fund, that is, a non-equity mutual fund, the gains would be LTCG having been held for more than 36 months and the tax would be at 20 per cent with indexation benefit. No grandfathering benefit is available on non-equity mutual funds. The cost of acquisition is indexed using the cost inflation indices of the years of purchase and sale. For example, assuming the index in 2015 was 120 and that in 2018 was 140, the cost of acquisition per unit would be ₹17.5 calculated as ₹15*(140/120), the gain would be ₹12.5 (30-17.5), and the tax would be at 20 per cent.

If the units were of an equity fund, bought in December 2017 at ₹15 per unit and sold in August 2018 at ₹30, the gains would be short term in nature, being held for less than 12 months. Tax at 15 per cent would be levied on profit of ₹15 (30-15) per unit; there is no grandfathering benefit since the gain is short term in nature.

Now, if the units were of a non-equity mutual fund, purchased in August 2016 and sold in August 2018, the gains would be short-term having been held for less than 36 months, and tax at the investor’s slab rate (5, 20 or 30 per cent) would be levied on ₹15 (30-15) per unit.

If only some of the units that were bought as lumpsum are sold, the above calculations apply only to those units that are sold. Also, the FIFO (first in, first out) rule applies in case of sale of lumpsum units bought on different dates. For instance, if 2,000 units are bought in August 2016, 1,000 units are bought in August 2017 and then 2,500 units are sold in August 2018, then to compute gains and tax, the sale comprises 2,000 units bought in August 2016 and 500 units in August 2017.

Sale of SIP units

In a systematic investment plan (SIP), investments are made at regular intervals (say monthly) in a mutual fund scheme and units are allotted to the investor, based on the NAV on the date of investment.

The tax treatment on sale of SIP units is the same as that on a lumpsum investment, except in one key aspect. In a lumpsum investment, the period of holding for the units sold is taken from the date of the investment, which does not change. But in a SIP, the period of holding has to be considered for each SIP instalment separately and the sale of units is calculated on a FIFO (first in, first out) basis.

Say, you invested ₹10,000 in an equity fund on the 15th of each month for three months — April 2017, May 2017 and June 2017 at an NAV of ₹10, ₹12.5 and ₹15 per unit.

You would have got 1,000 units in April 2017, 800 units in May 2017 and about 667 units in June 2017 — in all, about 2,467 units.

Now, say, you sold 2,400 units in end-May 2018 at ₹18 per unit. On FIFO basis, the units sold would be considered first as the 1,000 units from the April 2017 purchase, then the 800 units from the May 2017 purchase and, finally, the balance 600 units from the June 2017 purchase.

The gain on sale of 1,000 units bought in April 2017 and 800 units bought in May 2017 would be considered LTCG as they have been held for more than 12 months, but the gain on sale of 600 units bought in June 2018 will be STCG as it has been held for just about 11 months.

The LTCG here will be taxed at 10 per cent with grandfathering of gains up to January 31, 2018, while the STCG will be taxed at 15 per cent without the grandfathering benefit.

So, say, if the NAV of the units was ₹16 as on January 31, 2018, the LTCG would be ₹2 per unit (18 - 16) for the 1,000 units bought in April 2017 and 800 units bought in May 2017, and will be taxed at 10 per cent. The STCG on the 600 units bought in June 2017 would be ₹3 per unit (18-15) and will be taxed at 15 per cent.

The gain on sale of units bought in a SIP of a non-equity fund is calculated using the same FIFO logic, and then the relevant tax rates will apply (20 per cent with indexation for LTCG and tax slab rates for STCG).

Redemption through SWPs/STPs

In a systematic withdrawal plan (SWP), an investor withdraws money from her fund corpus on a systematic basis, say monthly, for meeting expenses or other purposes. On each withdrawal, there could be gains.

In a systematic transfer plan (STP), an investor transfers funds on a systematic basis from one fund scheme to another, say from a liquid fund (non-equity fund) to an equity fund, or say from an equity fund to a debt fund, or say, from one equity fund to another.

The motivations are different. For instance, in an STP from a liquid fund to an equity fund, the idea is to avoid lumpsum investment in the equity fund. Instead, the money is first parked in a safer liquid scheme and then routed into a riskier equity scheme over a period on a systematic basis, say monthly. STPs are considered redemptions and there could be gains. For instance, in an STP from a liquid fund to an equity fund, there could be gains on the units of the liquid fund redeemed, while in an STP from an equity fund to a debt fund, there could be gains on the equity fund units redeemed. The tax treatment of gains on SWPs and STPs is the same as that on SIP units.

That is, the units equivalent to the amount withdrawn are calculated on a FIFO basis, and tax on the gains is based on the type of fund, nature of gains (LTCG or STCG depending on period of holding), grandfathering benefit (depending on purchase date of equity funds), and tax rates.

For the units invested in another fund as part of the STP, the date of transfer will be the acquisition date.

Change in plans

Investors in mutual funds have the option of changing their scheme plans.

For instance, to improve returns, investors with know-how may choose to shift from a scheme’s regular plan (where the investment is made through a distributor) to a direct plan (where the investment is made directly).

Or investors could choose to shift from a scheme’s dividend plan to its growth plan — this could make sense now in equity funds from the tax angle, given that all dividends from equity funds are subject to dividend distribution tax of 10 per cent while LTCG in equity funds is taxed at 10 per cent only on gains above ₹1 lakh a year. Such changes in plans are considered transfers, and gains are taxed though they are still unrealised.

The tax liability will depend on the type of fund (equity or non-equity), type of investment (lumpsum or SIP), nature of gains (LTCG or STCG depending on period of holding), grandfathering benefit (based on purchase date of equity funds), and tax rates.

Sale of transmitted units

Mutual funds units cannot be gifted by one person to another. But an investor’s units can be transmitted to another on the investor’s passing away.

There is no tax on transmission. But when such transmitted units are sold, there is tax. The new investor steps into the shoes of the original investor. So, for the new investor who sells the units, the acquisition cost of the original investor applies and the holding period is calculated from the acquisition date of the units by the original investor. The grandfathering benefit will be available on equity funds, where applicable.

Taxing re-categorised and merged schemes

Over the past year, many mutual schemes have been re-categorised based on SEBI’s mandate. Some schemes have been merged with others. Re-categorisation or mergers of schemes, as such, do not attract tax. The value of the fund holdings does not change due to re-categorisation or merger. But when such schemes are sold, tax is payable on the gains. On sale of re-categorised schemes, the usual tax treatment applies on gains, as in the various scenarios mentioned earlier.

To calculate tax on the sale of merged schemes, the holding period is considered from the date on which the original scheme units was bought.

For instance, if scheme A is merged into scheme B, the date of purchase of scheme A units will be considered to determine the holding period.

Next, to compute the cost of acquisition of equity schemes as per Budget 2018 provisions to determine LTCG, the fair market value (FMV) of the fund that existed as January 31, 2018 is considered. Say, scheme A existed as of January 31, 2018; it was merged into scheme B in May 2018, and scheme B units were allotted in lieu of scheme A units.

Now, if scheme B units are sold in August 2018, the FMV of scheme A units as of January 31, 2018 will be considered to compute the cost of acquisition, to determine LTCG.

If the merger took place prior to January 31, 2018, and scheme B units issued in lieu of scheme A units, then the FMV of scheme B units as of January 31, 2018 will be considered to compute the cost of acquisition, to determine LTCG.

On STCG on sale of merged equity schemes, the cost of acquisition of the original scheme (A in the above example) is considered. Also, in the case of non-equity schemes, the cost of acquisition of the original scheme (A in the above example) is considered to determine LTCG and STCG.

 

 

 

Read the rest of this article by Signing up for Portfolio.It's completely free!

What You'll Get





TOPICS

Related

This article is closed for comments.
Please Email the Editor