Understand tax provisions before laying hands on any asset

Investors must pay tax on mutual fund investments once they redeem units and realise profits. There is no TDS nor is there any tax on accrued gain. Further, a switch transaction is considered the equivalent of a redemption transaction, and investors must pay taxes on the gains

“Binaa Kar ka Pravdhaan Jaane, Na Lagaao Asti Ko Haath;

Kar Kam Aur Yathochit ho, Samajh Ke Ho Lo Uske Saath.”

Translation: Without understanding tax-provisions, don’t lay your hands on asset;

See, tax is low and appropriate, please understand, embark, and invest.

“What is the difference between a taxidermist and a tax collector? The taxidermist takes only your skin-Mark Twain

Twain’s quote, and many by others, makes the word ‘tax’ sound too scary. Albert Einstein once said, “The hardest thing in the world to understand is the income tax.”

As taxation is here to stay, so we must learn to endure in a less painful manner. Though taxation is a vast and complicated topic, I would restrict my deliberations to taxation relating to mutual fund investments for resident investors only.

Breaking down the concepts of mutual fund taxation further into smaller bits makes it far easier to understand.

Type of funds-Schemes with equity taxation: Invest at least 65% or more of their net assets in listed equity securities or equity related instruments.

Schemes with Debt Taxation- Invest less than 35% in equity and related instruments.

Schemes with indexation benefit: Invest between 35% and 65% in equity or equity related instruments.

2. Capital gains/losses: Capital gains are the gains you generate when you sell/redeem a mutual fund unit for a higher price than its cost. Similarly, you have capital loss if you sell/redeem for a lower price than its cost.

3. Holding period: The holding period of mutual fund decide the rate of tax which you will have to pay capital gains. Your redemption/sell date tells whether it is short term capital gain or long-term capital. Income tax regulations encourage a longer holding period, which is why holding your investment for longer reduces your tax liability.

4. Dividend: A dividend is a part of the profits accumulated that the mutual fund house distributes to the investors of the scheme (i.e., dividends don’t require an investor to sell the asset). It is not treated as capital gain and must show under ‘Income from other sources’ and is taxed at normal rates, which is the slab rate applicable to individual. TDS is deducted as applicable provided dividend payment exceeds Rs. 5,000 within a financial year.

Point of taxation for mutual fund investments

Investors must pay tax on mutual fund investments once they redeem units and realise profits. There is no TDS nor is there any tax on accrued gain. Further, a switch transaction is considered the equivalent of a redemption transaction, and investors must pay taxes on the gains from the mutual fund units switched out.

The tax of capital gains from mutual funds based on classification.

In case of equity schemes, for holding period up to one year (short term capital gain) is taxed at 15% (plus applicable cess) , and for holding period greater than one year (long term capital gain that is over Rs. One lakh) is taxed at 10% (surcharge and cess as applicable).

In case of debt schemes both are taxed as per tax slab of investor. Surcharge and cess as applicable whereas in case of schemes where the equity portion is between 35%-65%, short term capital gain (holding period up to three years) is taxed as per tax slab of investor. And the long-term capital gain (holding period over three years) is taxed 20% with indexation benefit (surcharge and cess will be applicable).

Please note that tax on long term capital gain on debts fund is 20% with indexation benefit, if investment is done on before March 31, 2023. All investments made after April 1, 2023 and all gains from debt funds will be taxed as per your slab rate.

Taxation of capital gains when invested through SIPs: When investing through SIPs (Systematic Investment Plans) in mutual funds, the taxation of capital gains depends on the holding period of the units. The redemption of mutual fund units purchased through SIPs is processed on a first-in-first-out basis.

Tax benefits under Section 80C: Mutual funds also provide an opportunity for the investors to save taxes with regards to the eligible tax-saving investments under ELSS. ELSS is a particular category of mutual fund scheme which, subject to certain conditions, including a lock-in period for 3 years from the date of investment, renders tax benefits.

Strategies to reduce capital gains tax on mutual funds-Tax harvesting: Utilising tax harvesting involves selling a portion of equity mutual fund units annually to realise long-term gains and subsequently reinvesting the proceeds into the same fund. Investors can thereby keep their long-term returns below the Rs. one lakh threshold, thus avoiding long-term capital gains tax upon redemption.

For instance, if one has Rs. Four lakh in equity fund on March 1, 2023, with a 20% annual return, redeems it on March 3, 2024 for Rs. 4.80 lakh and reinvests the next day then the capital gains of Rs. 80,000 remains tax-free as it stayed below the Rs. one lakh threshold for that financial year.

Capitalise your losses: This approach involves booking long-term capital losses to offset against other long-term capital gains, effectively reducing the capital gains tax burden.

For instance, if an investor faced a loss of Rs. 40,000 on an investment valued at Rs. 1.6 lakh in January 2024, they could offset this loss against any long-term capital gains booked in the same year. By doing so, investors can reduce payable capital gains tax.

Kindly note: The above deliberations are for educative purposes only. An investor is advised to consult the tax-professional before taking any investment related decision.

(The writer is executive Vice-president, SBI Funds Management Limited; Translation and text by Ajay Mohan, practicing management accountant based in Navi Mumbai)