It is already a well-understood fact that mutual funds offer the best way for retail investors to participate in the markets. With the benefit of professional management and the benefit of diversification, mutual funds are in a position to outperform markets over a longer period. Thus they offer the best means of creating wealth over the long term. Mutual funds have another important role to play. They are extremely critical to help meet our long term goals. Typically, goals include our requirements like capital appreciation, liquidity, tax efficiencies, synchronizing withdrawals, timing redemptions etc. The beauty of mutual funds is that they have a wide variety of schemes like equity funds, debt funds, variable rate funds and money-market funds etc which are suited to each of these unique needs.
For investors, as much as it is important to understand the return and risk profile of mutual funds, it is also essential to understand the tax implications of mutual funds. Remember, taxes enter the picture at different stages of a mutual fund. For example, when the mutual fund distributes dividends, it has to pay dividend distribution tax (DDT) and that reduces your actual payout. Then there is the taxation at the hands of the unit holder at the time the dividend is received. Finally, there is the aspect of capital gains when the mutual fund units are redeemed at a profit. Let us look at each of them…
Dividend distribution tax (DDT):
In the last budget, the dividend distribution tax was raised from 15% to 17.65% for Indian companies and up to 28.84% for non-equity mutual funds. Of course, equity mutual funds are exempt from DDT as the companies paying out the dividend would have already paid the DDT and hence it would result in double taxation. However, the 3% hike in DDT is a huge hit as it proportionately reduces the total dividend paid out. At the end of the day, the company or the mutual fund pays out the net dividend after deducting the DDT.
Tax payable by unit holders on dividends:
Firstly, any dividends paid out by equity funds are totally exempt in the hands of the unit holder. Here equity funds include pure equity funds, balanced funds with more than 50% invested in equities and arbitrage funds that have half their portfolios in long cash market positions. All these categories of funds are exempt from tax on dividend incomes.
Even in case of debt funds, there is no tax payable on the dividend received in the hands of the unit holder. However, it needs to be recollected that the mutual funds has already deducted dividend distribution tax (DDT) in case of non-equity funds and hence the net dividends have already been reduced to the extent of this DDT.
There is also an aspect that investors need to understand. Prior to 2005, large corporates and HNIs would buy the units ahead of the dividend record date and sell it immediately after the record date at a capital loss. Effectively, they strip the money out of the units as dividends. However, since dividends were tax-free, the short term loss arising from the units could be written off against their other short term gains. To prevent this practice, any units bought 3 months prior to the dividend record date or sold within 9 months of the record date does not get the benefit of tax rebate. This has effectively made dividend stripping unviable currently.
Tax on Capital Gains…
Capital gains taxation depends on whether it is short term or long term capital gains. In case of equity funds, any holding under 12 months is classified as short term and holding beyond 12 months is classified as long term capital gains. In case of equity funds, long term capital gains are tax free whereas short term capital gains are taxed at 15%. One needs to remember here that since long term gains on equity funds are exempt from tax, any long term loss arising from equity funds is not eligible for a write-off against other long term capital gains. It also needs to be remembered that when you redeem equity funds you are liable to pay securities transaction tax (STT) on the value of your redemption at the extant rates. Please note that the above method of capital gains calculation is applicable only when the mutual fund unit is held as an investment. In case the mutual fund units are held as stock-in-trade in business, then it gets classified as business income and gets taxed at the peak tax rate.
In case of non-equity funds, the definition of long term is 3 years and not 1 year. In case of non-equity fund, long term capital gains are taxed at the rate of 20% plus cess. Of course, the benefit of indexation is available in such cases. Short term gains in case of non-equity funds is payable at the peak tax rate of the individual unit holder inclusive of cess.
Then there is the question of TDS on capital gains. Currently, in case of resident Indians, no TDS needs to be deducted in case of redemptions for any capital gains that may arise. However, in case of non-resident Indians (NRIs), the TDS has to be deducted by the mutual fund on any capital gains at the extant rates.
One needs to remember that tax implications make a substantial difference to the effective net yield that you earn on your mutual fund holdings. It is therefore imperative to have a detailed understanding of the tax implications to use this product more effectively.
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