MUTUAL FUND TAXATION

TAXATION OF MUTUAL FUND INVESTMENTS

There are different tax implications for investors when they invest their funds into mutual fund schemes. This depends upon their status, the type of scheme that they have invested in and the nature of the gain that they have earned. These are not very complicated and a lay investor can check out the kind of tax liability that they will encounter. Here we shall take a look at all the factors that come into play while looking at the tax implications for investors.

DIFFERENT TYPES OF SITUATIONS WHERE TAX HAS TO BE PAID

The first question before an investor is to check out what is the benefit that they have received and then classify this benefit under the appropriate head due to which the necessary tax effect will be given. In effect one can say that there are two main types of gains that comes from mutual funds for investors.

The first is the dividend received from the mutual fund. As far as the dividend is concerned there are two options that one can choose in receiving the dividends. The first is the dividend payout option where the dividend is actually received by the investor either through a cheque or a direct credit into their bank account. In this case the situation is very clear, as the payout will be classified as dividend for the purpose of taxation. The second is the dividend reinvestment option where the dividend is not received in cash but is converted into additional units in the scheme. In this option too it is considered that the investor has first received the dividend when the figure is announced and after that there is further purchase of units from the money. The effect that is given here will consider the amount of dividend reinvested as the dividend received for the purpose of tax.

The second benefit that investors get from mutual fund schemes is that of a capital gain or when there is a loss a capital loss. This happens when the sale price of the units is more than the cost price at which the units were bought. There are two types of capital gains. When the units of the scheme are held for a period of not more than 12 months then the gains that arise form the sale are classified as short term capital gains and the appropriate tax is levied. On the other hand when the units are held for a period of more than 12 months then the gains are classified as long term capital gains. In a growth option selected by the investor the gains will be capital gains due to the difference in the cost price on purchase and the sale price. In case of the dividend options while there will be income from dividends there can also be capital gains in the picture because scheme do not always pay out the entire sum that it gains as dividend as there is also an addition to the NAV of the scheme.

EQUITY ORIENTED SCHEME

The gains that arise for the investor shave to be seen with respect to the different types of schemes that are present in the market. The first question is which schemes would be classified as equity oriented schemes. As per the latest modified definition any scheme that has more than 65% of its assets invested in equities of domestic companies will be considered as equity oriented schemes. This means that even balanced scheme with this percentage of assets in equities would be classified under this head.

As far as dividends from equity oriented schemes are concerned there is no tax to be paid by the investor on the amount received hence the entire amount that is received by the investor in their hands will be completely tax free. The good news for the investors is that no dividend distribution tax will be charged on the equity oriented schemes whenever dividend is declared.

For example consider an investor who holds 900 units in equity oriented schemes whose face value is Rs 10 per unit and the NAV of the dividend option is Rs 45 per unit. If this scheme declares a 50% dividend then the dividend to be paid to the investor will be Rs 5 per unit, which comes to Rs 4,500 and this amount, will be tax free in their hands. Further there is no dividend distribution tax to be paid by the scheme too.

When it comes to capital gains too there is a favourable treatment for equity oriented funds. There is however the securities transaction tax payable only at the time of the sale of equity oriented funds. The long term capital gains on such schemes that have paid the STT will be zero while the short term capital gains on such scheme will be at 10%.

For example consider a purchase made by an investor in an equity oriented scheme on January 1, 2005 of 1,000 units at Rs 12 per unit. If he sells the units on March 20, 2006 at Rs 15 per unit (after STT) then there is a gain of Rs 3,000 for the investor as long term capital gain. There will be STT paid at the time of the sale but the gain will not be liable for tax. If the same investment had been sold at Rs 15 in September 2005 then the gains would have been short term capital gains and a payment of 10% plus surcharge plus cess would be required from the investor.

The key point for a scheme to be classified as equity oriented is the 65% holding and hence one will witness that even balanced funds are trying to ensure that their offer documents are in tune with these guidelines so that they are able to get the tax benefit of the equity oriented schemes resulting in a lower tax outgo for the investors.

DEBT ORIENTED SCHEMES

The tax structure for investors in debt oriented schemes is slightly different and hence one has to pay close attention to the various types of gains or losses that have originated in such schemes.

As far as the dividends from debt oriented schemes are concerned the investor does not have to pay any tax on the dividend that is received by them. However there is an indirect expense for the investor in the form of dividend distribution tax that is present on such schemes, Here there are two rates for dividend distribution tax depending upon the category of the investor who is receiving the dividend payout. For investors who are individuals and Hindu undivided families the tax payout is 12.5% plus surcharge plus cess while the figure for categories other than these two the rate is 20% plus surcharge plus cess. Thus individuals will witness an indirect effect because the tax will be charged off to the net asset values of the fund.

When a dividend is declared in a debt fund there are two figures that are being talked about. The first is the gross dividend and the second is the net dividend. The net dividend is the important figure for the investor to consider because this is the payout that they will receive from the fund. So when an investor holds 2,000 units in a debt fund and the fund comes out with a net dividend of Rs 0.5 per unit then the actual payout that will be received by the investor will be Rs 1000. This figure is entirely tax free in the hands of the investor.

Then there are capital gains that would arise from the investment in such schemes. Here where there is a short term capital gains the figure of the gain will be added to the income of the individual and then taxed at the applicable rates. This means that the tax rate figure could jump to as high as 30% as several investors will fall into that particular tax bracket.

Consider the case where an investor bought 3,000 units in a debt oriented fund in April 2005 and then sold it in August at a gain of Re 1 per unit. In this case the short term capital gains is Rs 3,000 for the investor. This sum will be added to the income of the individual in the normal course which means that if the taxable income of the person making the gain is say Rs 3.2 lakh then this will be added to the income and the applicable rate here is 30% plus cess when the tax calculation is made.

On the other hand where there is long term capital gains there is a choice for the investor to make in terms of the rate of the tax that they will pay. The investor can either pay 10% tax without taking the benefit of indexation or pay 20% after taking the benefit of indexation. The benefit of indexation is the method where by the investor raises the cost of the purchase of the investment depending upon the year in which the purchase is made and the year in which the sale is made. There is a cost inflation index that is announced each year by the tax authorities and this is then used for the purpose of raising the cost so that that investor has a lower burden to pay as tax. There is no securities transaction tax in the case of debt oriented schemes.

Take an example of a long term capital gains where an investor has bought 1,000 units in January 2003 at Rs 12 per unit. This was later sold in January 2005 at Rs 14 per unit. In terms of the calculation here two options have to be considered. The first is 10% of the gain, which is Rs 204 ( 10% of Rs 2,000 plus cess). The second figure is the gain after applying the cost inflation index which comes to Rs 227 ( Cost price Rs 12.88 after indexation plus cess). The investor can choose the lower of the two and pay the required tax that is beneficial to him.