We all have been advised by people to invest in mutual funds, but not everyone knows what happens to the profits earned from mutual fund investment. It is important to understand the taxation system of your investments before deciding to invest.
A mutual fund is a type of investment where a fund manager/asset management company raises capital from investors having common investment objectives. This pooled money is further invested in various classes of assets like equities and bonds based on the objectives of the investment scheme. There are two types of returns that can be generated from mutual funds – capital gains and dividends.
Capital gain in a mutual fund is the difference between the cost of acquisition of the assets and the selling value. Cost of acquisition is the value at which an asset was acquired, and sale of consideration is what is received as a result of the transfer. It is imperative to note that debt funds are indexed to arrive at the purchase price. Indexation is recalculating the price at which an asset was purchased by making adjustments for the inflation index.
All capital assets are bifurcated into two – short term and long term, which is determined by the duration for which the assets have been held by an individual.
| Fund | Short-term capital gains | Long term capital gains |
| Equity funds/hybrid equity-oriented funds | Held less than 12 months | More than 12 months |
| Debt funds/hybrid debt-oriented funds | Held less than 36 months | More than 36 months |
Let’s discuss the capital gain tax calculation of mutual funds.
Short term capital gain is taxed at 15% for equity funds; whereas for debt funds, the gains are taxable as per an investor’s income tax slab.
With the recent amendment in the Income Tax Act, long term capital gain (LTCG) is taxed at the rate of 10% above Rs. 1 lakh on sale units of equity-oriented funds and equity shares.
Apart from the above, long term capital gain on debt mutual funds carries a tax of 20% after indexation benefit.
Let’s dive into the calculation of capital gain tax on mutual funds.
Example: If Mr. ABC purchased shares in December 2015 at Rs. 5,00,000 and sold it in July 2020 at Rs. 14,00,000 (tenure more than 12 months) the income will be considered as a long-term capital gain.
To calculate mutual fund capital gain:
Cost inflation index for 2015 is 254, hence the indexed cost of acquisition is Rs – 5,00,000 X (254/100) = Rs. 12,70,000
Total taxable gain is Rs. 14,00,000 – Rs. 12,70,000 = Rs. 1,30,000
Mutual Funds LTCG above Rs. 1 Lakh is taxed at 10% = Rs. 1,30,000 X 10% = Rs. 13,000
Over and above the capital tax gain, cess is also charged by the government
Exemptions
Under section 10(38) of the Income Tax Act, there are conditions prescribed, if fulfilled, that will make long term capital gain arising after the transfer of equity-oriented mutual funds or equity shares free from taxes.
- The transfer should be of long term assets and must have been made on or after 1st October 2004.
- The sale transaction is required to be liable to the STT (Security Transaction Tax).
Under section 54, individuals can claim tax benefits on the sale of an asset from LTCG on mutual fund investment if the asset has been purchased one year prior or after two years from the sale date. Alternatively, one can also construct a property with the capital gain from sales. In such cases, the construction should be completed within three years from the transaction date.
In addition to the above, market volatility has a major role in long term capital gain on mutual funds. Tax amendments are applicable if the funds are held for more than one year from the date of allotment.
