NISM Mutual Fund Exam Notes: Chapter 8 – Taxation Simplified for Quick Revision

Investment returns are often subject to taxation, affecting the net income received by investors.
Understanding tax implications is essential for investors.
This chapter focuses on taxation related to mutual funds.
Mutual funds invest in various instruments, making tax knowledge crucial.
Distributors must know both the tax on mutual fund income and on investor returns.

Applicability Of Taxes In Respect Of Mutual Funds :

Tax Impact on Returns: Taxation affects mutual fund investment returns at two levels—income earned by the fund and by the investor.
Fund Income Taxation: Income earned by mutual funds (interest, dividends, capital gains) is exempt from income tax under Section 10(23D) of the Income Tax Act.
Investor Income Options: Investors can opt for Income Distribution cum Capital Withdrawal (IDCW) or Growth plans. IDCW gives periodic payouts; growth plans give capital gains at redemption.
Capital Gains vs Dividends: Tax treatment varies between capital gains and dividends, based on holding period, scheme type, and investor category.
Fund Categories: Funds are classified as equity-oriented (≥65% in listed equities) or non-equity-oriented (like fund-of-funds), which affects tax rates.
Investor Type Matters: Taxation differs for resident Indians, NRIs, and non-individuals. In joint holdings, the first holder is considered the income recipient.
Recent Tax Changes: Budgets of 2023 and 2024 introduced new capital gains tax rules, effective from April 1, 2023, and July 23, 2024, respectively, affecting both investment and redemption dates.

Capital Gains :

Capital gains arise when mutual fund units are sold at a different price than purchased—profits are taxable.
Short-term vs. long-term gains depend on holding periods: 12 months for equity-oriented funds, 24 months for others.
Post-April 2018, long-term capital gains (LTCG) from equity mutual funds are taxed at 10%.
Grandfathering provision ensures gains till January 31, 2018 are tax-exempt; the higher of purchase price or NAV on that date is used as the cost base.
Example 1: If sale value is lower than Jan 31, 2018 NAV, LTCG is zero.
Example 2: If sale value is higher than Jan 31, 2018 NAV, only the excess is taxed.
Tax exemption is provided for LTCG up to Rs. 1.25 lakhs annually; only the surplus is taxed.

Dividend Income ( IDCW Option ) :

Earlier Tax Regime: Dividend income from mutual funds was tax-free for investors, but funds paid a Dividend Distribution Tax (DDT), reducing NAV and indirectly affecting returns.
Post-2020 Budget Change: DDT was abolished, and now dividends are taxable in the hands of investors at their applicable income tax rate.
Impact by Tax Slab: Higher-income investors now pay more tax on dividends, while tax-exempt entities benefit as they no longer bear the indirect burden of DDT.
Set-off & Adjustments: Unlike DDT, which couldn’t be adjusted, the new tax on dividends can be offset using applicable exemptions.
NAV Impact Remains: In both regimes, NAV drops more than what the investor ultimately receives after tax.
Growth Option Advantage: Growth option is more tax-efficient due to tax deferment and compounding benefits.
Change from April 1, 2021: Funds must now disclose the split between income and capital in dividends, and tax must be calculated accordingly.

Stamp Duty On Mutual Fund Units :

Effective July 1, 2020, mutual fund unit purchases (including SIP, STP, switch-ins, dividend reinvestment, etc.) are subject to stamp duty of 0.005% of the investment amount.
Transfers of mutual fund units (e.g., between demat accounts) are subject to stamp duty of 0.015%.
Stamp duty applies to both physical and demat units, and is deducted before unit allotment.
The stamp duty rules stem from amendments to the Indian Stamp Act, implemented via notifications between 2019 and 2020.

Setting Off Of Capital Gains & Losses Under Income Tax Act :

The Income Tax Act allows setting off losses against gains within certain limits across different income heads.
Capital losses cannot be set off against non-capital income like salaries.
Short-term capital losses can be set off against both short- and long-term capital gains.
Long-term capital losses can only be set off against long-term capital gains.
In mutual funds, bonus stripping rules restrict setting off capital losses from bonus-related transactions.
If units are bought within 3 months before the bonus record date and sold within 9 months after, any loss on sale is disallowed and treated as the cost of bonus units.

Securities Transaction Tax :

STT (Securities Transaction Tax) is applicable on the sale/redemption/switch of equity-oriented mutual fund units, not on purchase.
STT is not applicable to debt securities or debt mutual fund transactions.
STT Rates:
Purchase of equity mutual fund units: 0% (Nil)
Sale (delivery-based): 0.001%
Sale (non-delivery based): 0.025%
Sale to mutual fund: 0.001%

Tax Benefit Under Section 80C Of The Income Tax Act :

ELSS (Equity Linked Savings Schemes) are eligible for tax deduction under Section 80C of the old tax regime, up to ₹1.5 lakh per individual/HUF per year.
ELSS investments have a 3-year lock-in period; SIP investments are locked in individually from their respective dates.
Reinvested dividends under reinvestment plans also face a 3-year lock-in, though most AMCs now offer only growth or dividend payout options.
Tax benefit under Section 80C applies only to the first holder in joint accounts.
Under the new tax regime (post-Budget 2020), Section 80C deductions are not available, so ELSS functions like a standard equity mutual fund with a lock-in.
Some retirement-oriented funds also qualify under Section 80C but have a 5-year lock-in; not all such funds are eligible, so verification is needed.

Tax Deducted At Source :

No TDS is applicable on repurchase proceeds for resident investors.
TDS applies to certain non-resident investments, depending on investor type, investment nature, and income type.
For residents, a 10% TDS is deducted on mutual fund dividends if they exceed ₹5,000.
DTAA agreements may offer reduced TDS rates for non-residents.
Non-resident investors must provide documentation to claim DTAA benefits.

Applicability Of GST :