Long-Term Capital Gain Tax on Mutual Funds

What is tax on mutual funds?

The profits earned from the investment made in mutual funds are known as capital gains and these gains are subject to tax. It is important to understand how your gains will be taxed before investing in mutual funds.

No indexation benefit will be available for calculating long-term capital gains on Debt Mutual Funds (mutual funds investing less than 35% of their corpus in equities or equity-related instruments). Long-term capital gains on such debt funds will now be taxed according to the investor’s applicable slab rates. This change is applicable only for debt fund investments made after April 1, 2023.

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What is Long-term Capital Gains Tax on Mutual Funds?

Long-term capital gains on mutual funds arise when you sell a capital asset after holding it for a period of more than 1 year. If your long-term capital gains are more than Rs.1 lakh, such gains are taxable. After the introduction of section 112A, the tax rate for LTCG on Mutual funds is 10% without any indexation benefit.

However, tax on long-term capital gains is only applicable in the year when it is sold or redeemed. Therefore, capital gains on mutual funds do not apply every year.

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Key Factors Influencing Mutual Fund Taxation

Mutual funds are subject to specific tax regulations based on various factors. Below are the essential aspects that affect the taxes levied on mutual funds:

Fund Types

Taxation rules vary depending on the type of mutual fund. Different fund categories include:

• Equity Mutual Funds
• Debt Mutual Funds
• Hybrid Mutual Funds
  Each type has distinct tax implications due to differences in investment strategies and asset allocations.

Dividend

A dividend is a portion of the profit distributed to investors by mutual fund houses.

• Equity Funds typically offer dividends as a reward to long-term investors.
• Debt Funds may also distribute dividends, which are taxed differently based on holding periods and other factors.

>Capital Gains

Capital gains occur when investors sell their mutual fund units at a profit—i.e., selling them at a price higher than the purchase price.

• Short-term capital gains (STCG) are taxed at a higher rate if investments are sold within a specific period (e.g., less than 3 years for equity funds).
• Long-term capital gains (LTCG) are taxed at a lower rate, offering tax benefits for holding periods longer than the stipulated duration.

>Holding Period

The time duration between the purchase and sale of mutual fund units plays a significant role in taxation.

• A longer holding period generally results in lower tax liabilities.
• For instance:
  • Equity Mutual Funds: If held for more than 1 year, long-term capital gains are taxed at 10% (without indexation).
  • Debt Funds: Short-term capital gains are taxed at your applicable income tax rate, whereas long-term capital gains are taxed at 20% with indexation benefits.

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What are the Tax Implications on Different Types of Mutual Funds?

Below are the different types of mutual funds and the tax provisions applicable to each of them -

Taxation of Capital Gains on Equity Funds

Equity funds are mutual funds that invest in equity shares of different companies. There are both tax-saving and non-tax-saving equity funds in the market. Tax-saving equity funds are known as Equity Linked Savings Scheme (ELSS). These funds have a lock-in period of 3 years. This results in long-term capital gains. These equity funds are taxed at 10% if the gains exceed Rs.1 lakh.

Here’s an example -

Mr.X invested Rs.5 lakhs in an equity fund on 1st April 2019 and sold it after 30th September 2021 for 7 lakhs. Therefore, his long-term capital gain on shares will be Rs.2 lakhs. Since the LTCG on shares during the FY exceeds Rs.1 lakh, it will be taxed at 10%.

LTCG tax on shares = Rs.2,00,000 * 10% = Rs.20,000

Taxation of Capital Gains on Equity-Oriented Hybrid Funds

Such mutual funds invest in both equity shares as well as debt. However, in the case of equity-oriented hybrid funds, 65% of the funds should be invested in equity shares, and the remaining 35% should be invested in debt instruments. Since a major portion of the investment is in equity shares, the capital gains on these funds are similar to that of equity funds.

Taxation of Capital Gains on Debt Funds

These mutual funds purchase debt instruments from the market. The long-term capital gains on mutual funds investing in debt instruments are taxed at @20% after considering the benefit of indexation. The indexation is done on the basis of the cost inflation rate. The process of indexation can reduce the capital gain chargeable to tax. The formula for calculating the cost inflation index (CII) is given below.

(Actual cost of acquisition X Index of the current year) / Index of the base year

Taxation of Capital Gains on Debt-oriented Balanced Funds

These mutual funds invest in both equity and debt instruments. However, in this type of fund, 60% of the amount is invested in debt instruments, and 40% is invested in equity shares. 20% tax rate is applicable on the capital gains that arise from selling debt-oriented balanced funds. The tax amount is calculated only after taking into account the benefit of indexation.

Taxation of Capital Gains on Unlisted Equity Funds

The long-term capital gains arising from the sale of unlisted equity funds attract tax at @20% after the benefit of indexation. The tax rate for such equity funds also includes cess tax and surcharge.

Here’s a summary of the tax rate applicable to different types of mutual funds -

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How are Long-term Capital Gains on Systematic Investment Plans (SIP) Taxed?

In the case of Systematic Investment Plans (SIPs), each installment paid is considered to be a separate investment and therefore taxed separately. In other words, the gains from each SIP installment are taxed separately. The tax rate depends on the type of funds in which it was invested.

For example, if Mr. B decides to start an SIP of Rs.10,000 every quarter in an equity fund for 12 months. His capital gains from each SIP is Rs.4,000. He redeems his entire investment after 12 months. Then, the total corpus will be Rs.56,000 (Rs.40,000 + Rs.16,000).

The short-term capital gain tax will be levied only on Rs.12,000, which are gains from later installments. Long-term capital gains do not apply on mutual funds from the first installment as the amount is below Rs.1 lakh.

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How to Calculate Tax on Long-term Capital Gains on Mutual Funds?

Before you go on to understand the calculation of tax on long-term capital gains on mutual funds, let's first understand some terms associated with it that you must know -

• Full Value of Consideration - It refers to the consideration already received or yet to be received by the seller as a result of the transfer of capital assets.
• Cost of Acquisition - Cost of acquisition refers to the cost incurred for acquiring an asset. In other words, the price paid at the time of purchasing an asset is known as its cost of acquisition.

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Example of Calculation of Long-term Capital Gains on Mutual Funds

Suppose Mr.X purchased shares worth Rs.50,000 in January 2016 and sold them at Rs.3,00,000 in February 2018. Since the total investment tenure is more than one year, the gains will be considered long-term capital gains.

For calculating the long-term capital gains on mutual funds -

• The Full value of consideration will be - Rs.3 lakhs.
• The cost inflation index for the year mentioned is 280. Then, the indexed cost of acquisition will be - 50,000 X (280/100) = Rs.1,40,000.
• The total taxable amount of capital gains is = Rs.3,00,000-Rs.1,40,000 = Rs.1,60,00.

As mentioned in the table above, LTCG on mutual funds above Rs.1 lakh is subject to tax at @10% = Rs.1,60,000 * 10% = Rs.16,000

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What are the Exemptions Available on Capital Gains?

Given below are the exemptions available on long-term capital gains on mutual funds -

Section 10(38) -

This section exempts the capital gains on mutual funds from tax if -
The transfer was made after 1st October 2004
A transfer of a long-term asset took place
A sale transaction attracts STT, i.e., securities transaction tax.

Section 54F -

You can get tax benefits on the sale of an asset under the following conditions -
You buy an asset 1 year before or a few years after the date of sale.
You have constructed a property with your capital gains from sales. This construction should be completed within 3 years from the date of sale.

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How to Save on Long-term Capital Gains?

Individuals can enjoy a long-term capital gain tax exemption on shares through Section 54F. To benefit from this provision, they must meet specific criteria:

• Reinvest the net consideration amount received from selling shares in up to two real estate properties. Previously, prior to Budget 2019, the limit was restricted to one housing property per person.
• The reinvestment should take place either one year before the sale or within two years after it.
• Alternatively, individuals can opt to invest their consideration amount in a construction project. However, the construction must be completed within three years from the date of the sale or transfer of shares.
• To avail of the exemption on the entire capital gain amount, individuals must reinvest the entire net consideration value. If this isn't feasible, the exemption on capital gain will be determined based on the proportion of the consideration amount invested.

Now that you know about the taxation of long-term capital gains on mutual funds, you can plan your investments in a manner that minimizes your tax liability. And if you are seeking professional help or need assistance with planning your taxes, or have tax-related queries, you can reach out to our tax experts, who make sure you don’t find taxes intimidating. Hire Online CA Now!

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