FAQs: Tax benefits on mutual funds Last Updated: January 31, 2005 08:45 IST

Many people invest in mutual funds with a view to saving taxes. So what are the tax benefits
investors get on investing in mutual funds? What tax rates are applicable? What are the benefits to overseas investors. Read on to find out. . . What are the tax benefits investors get by investing in Mutual Funds? Since, April 1, 2003, all dividends declared by debt-based mutual funds are tax-free in the hands of the investor. A dividend distribution tax of 12.5% (including surcharge) is be paid by the mutual fund on the dividends declared by the fund. Investors in ELSS (equity-linked savings schemes) can avail rebate under Section 88 of the Income Tax Act, 1961 on investment up to Rs 10,000 subject to the various conditions laid down in the said Section.

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The actual amount of rebate depends on the level of income of the investor. Is a capital gain on sale/transfer of units of mutual fund liable to tax? If yes, at what rate? Section 2(42A): Under Section 2(42A) of the Act, a unit of a mutual fund is treated as short-term capital asset if the same is held for less than 12 months. The units held for more than 12 months are treated as long-term capital asset. Section 10(38): Under Section 10(38) of the Act, long-term capital gains arising from transfer of a unit of mutual fund is exempt from tax if the said transaction is undertaken after October 1, 2004 and the securities transaction tax is paid to the appropriate authority. Section 111A: Under Section 111A of the Act, short-term capital gains arising from transfer of a unit of mutual fund is chargeable to tax @ 10% (plus applicable surcharge) if the said transaction is undertaken after October 1, 2004 and the securities transaction tax is paid. However, such securities transaction tax will be allowed as rebate under Section 88E of the Act if the transaction constitutes business income.

Section 112: Under Section 112 of the Act, capital gains, not covered by the exemption under Section 10(38), chargeable on transfer of long-term capital assets are subject to following rates of tax:
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Resident Individual & HUF --- 20% plus surcharge. Partnership Firms & Indian Companies --- 20% plus surcharge. Foreign Companies --- 20% (no surcharge).

Capital gains will be computed after taking into account cost of acquisition as adjusted by Cost Inflation Index notified by the central government. 'Units' are included in the proviso to the sub-section (1) to Section 112 of the Act and hence unit holders can opt for being taxed at 10% (plus applicable surcharge) without the cost inflation index benefit or 20% (plus applicable surcharge) with the cost inflation index benefit whichever is beneficial. Under Section 115AB of the Income Tax Act, 1961, long-term capital gains in respect of units purchased in foreign currency by an overseas financial organisation held for a period of more than 12 months will be chargeable at the rate of 10%. Such gains will be calculated without indexation of cost of acquisition. No surcharge is applicable for taxes under section 115AB, in respect of corporates. What are the tax benefits for foreign investors? Section 115E: Under Section 115E of the Act, capital gains chargeable on transfer of long-term capital assets of an Non-Resident Indians (NRIs) are subject to following rates of tax:
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Investment income: --- 20% Long term capital gains: --- 10%

Section 10(23D): Under provisions of Section 10(23D) of the Act, any income received by the Mutual Fund is exempt from tax. Section 115R: Under Section 115R, the Income distributed to a unit holder of a Mutual Fund shall be charged to following rates of tax to be payable by the Mutual Fund.
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Amounts distributed to individual or HUF: 12.5% Amounts distributed to others: 20.0%

However, the above distribution tax will be exempted for open-ended Equity-Oriented Funds (funds investing more than 50% in equity or equity related instruments). Are there any other tax benefits related to mutual funds? Under Section 88, contributions made from taxable income in the specified investments qualifies for a tax rebate of 20% where gross total income is up to Rs 150,000 and 15% of the invested

amount where gross total income is between Rs 150,000 and Rs 500,000, subject to a maximum aggregated ceiling of Rs 70,000. For investment in infrastructure bonds and/or equity-linked saving schemes (ELSS) (not exceeding Rs 10,000/- under clause (23D) of Section 10), or eligible issue of equity shares or debentures the maximum qualifying investment limit for tax rebate is Rs 100,000. However, such tax rebate is not available in respect of tax on long-term capital gains as per Section 112 and short-term capital gains as per Section 111A of the Act. Is there any wealth tax applicable to mutual fund investments? No. Units held under the Scheme of the Fund are not treated as assets within the meaning of Section 2(EA) of the Wealth Tax Act, 1957 and are, therefore, not liable to Wealth Tax. Is there any gift tax applicable to mutual funds investments? No. Units of the mutual fund may be given as a gift and no gift tax will be payable either by the donor or the donee; since mutual funds do not fall within the purview of the Gift Tax Act. How can I avoid payment of long-term capital gains on mutual fund investments? The capital gain, which is not exempt from tax as explained above, can be invested in the specified asset mentioned below within 6 months of the sale. Specified asset means any bond redeemable after 3 years:
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Issued on or after April 1, 2000 by NABARD (National Bank for Agriculture and Rural Development) or NHAI (National Highways Authority of India) Issued on or after April 1, 2001 by the Rural Electrification Corporation Ltd Issued on or after April 1, 2002 by the National Housing Bank or by the Small Industries Development Bank of India.

Such capital gains can also be invested in any residential house property in accordance with Section 54F of the Act and claim exemption from the capital gains.

When it comes to tax planning in case of mutual funds, the most obvious option may not

always be the best option. Investors seeking a regular income from mutual funds usually opt for the dividend option. They assume that the tax-free dividend payout is more efficient than systematic redemption of units from a growth option-but that may not be the case. There are many interesting aspects to mutual fund investing where the obvious choice may not always be the best. The tax provisions, whatever they are, are unavoidable. However, there are some general observations that are required to be understood as they can lead to a lowering of the tax liability. The choice, quite obviously, has to be made by the investor himself depending on his needs. Listed below is a check list which the investor should keep in mind before deciding his options in case of investing in a mutual fund.

Double Indexation Benefit – In some cases it is better to aim for the double indexation benefit rather than pure tax free income. When calculating the capital gains in case of redemption of units, an investor can calculate capital gains by choosing between two options - 10 per cent without indexation or 20 per cent with indexation. An investor, at the time of withdrawal, should consider both and choose the lower tax option. At this point the concept of double indexation can be useful. Double indexation gives an investor the advantage of indexing his investment to inflation for two years while remaining invested for a period of slightly more than an year. This can be done if the investor puts in his money just before the end of a financial year and withdraws it immediately after the end of the next financial year. For instance, had an investor put in money in a fund on 25 March 2001 (6 days before the end of FY on 31 March 2001) and withdrawn it on 5 April 2002 (after the end of FY 2001-2002) he would have got benefit for two financial years (2000-01, 2001-02) since the investment was made in the FY before last (2000-01). Depending on the quantum of gains in the scheme and the inflation index, the tax liability could be lowered by availing of double indexation. Switch options carefully- switching options-dividend to growth or vice versa-amounts to redemption from one option and fresh investment in the other option. And, this redemption attracts capital gains tax. So, it is important that an investor chooses the option carefully. This can be done through a careful analysis of one's cash flow needs. How bonus units lower capital gains- Unlike the case with common stock, a bonus issue in mutual funds carries nothing but a liquidity and tax advantage and that too under a given set of assumptions. A bonus carries no value because the total wealth of the unitholder remains the same. However, as the NAV adjusts down, depending on the ratio in which the bonus is granted, it serves to lower the cost of exit on the existing units. In short it reduces capital gains payable. A bonus issue could, therefore, partially increase liquidity by facilitating early withdrawal for those fearing to redeem on account of tax liability. The flip side ofcourse is that the cost of bonus units is deemed to be zero for tax purposes and that whenever those are withdrawn a tax will be levied on the gains. So, while less tax on existing units is compensated for by greater tax liability on bonus units (because their value is deemed to be zero), the advantage is that withdrawal of existing units can be made even before the end of one year. This is because any gains in the units may have been reduced if not eliminated altogether due to the bonus issue. When systematic withdrawal is better than dividend receipts-the prevailing tax provisions provide an interesting way of not only receiving regular income but also paying less tax. This can be done by systematically withdrawing the gains from the investment instead of claiming dividends. To do this an investor needs to opt for the Growth option of a mutual fund scheme and stay invested in the scheme for atleast one year. After one year, the investor can direct the mutual fund to systematically redeem units worth a fixed amount or units equivalent to the gains in the scheme. This way, the investor is assured of regular inflows. The benefit of doing this is that it is a more tax efficient way of receiving regular income. This is because whenever the units are withdrawn capital gains is charged on the difference between the purchase price and redemption price. So, if an amount equivalent to the gains is withdrawn then tax is levied on the amount of gains less the cost of units being redeemed to distribute this gain. Had these gains been distributed as dividend, tax would have been levied on the entire amount of gains. This would have meant a higher tax payout.

Dividend Reinvestment –the right choice for open-end equity schemes - tax laws prevailing at the moment specify that dividend payouts of all funds except UTI's US 64 and open ended equity schemes are subject to a distribution tax of 10 percent. This exemption granted to open end equity funds can be turned to one's advantage. An investor can take advantage of this provision by investing in the dividend reinvestment option of the scheme. The benefit of this is that due to the dividend declared in the units of the scheme the NAV declines by the amount of dividend.This, then brings down the redemption price of the units which in turn lowers the amount of capital gains. The advantage of dividend reinvestment therefore is twinfold. One, is that the amount of gains reduce and other is that dividend gets reinvested in the scheme automatically without any fresh procedural hassles. Invest for the long term - apart from being one of the fundamental tenets of sound investing, investing for the long term is also smart from the tax angle. Units held for more than an year are eligible for long term capital gain unlike short term capital gain which is taxed as a part of the unitholder's total income. While the maximum tax that will need to be paid on long term gain is limited to 10 per cent, tax on short-term capital gain can vary depending on other components of the unitholder's total income.

At 45 years or above, your insurance needs are probably taken care of already. If they aren't then, you can bridge the shortfall by taking some additional term insurance. Ensure you have a pension policy in place as retirement is less than 15 years away and your investments need to be more retirement-oriented. A good thing for the tax-paying investor is that tax benefits related to 'Pension' fall under a different Section (Section 80 CCC) as opposed to other forms of life insurance that attract tax benefits under Section 88. What this means is that you can buy pension and term insurance for instance, and still get a dual tax benefit. You can invest in an ELSS provided you aren't too close to retirement (around 60 years), in which case the risk-return profile of the mutual fund scheme would work against your own. At this stage, your PPF account is probably close to maturity in which case it makes more sense to increase investments in PPF. You not only get a tax benefit, but can also make withdrawals relatively sooner. Having read our recommended asset allocation for investing to save tax, there are some important pointers for investors: Exhaust the Rs 100,000 investment limit by first taking life insurance before considering any other investment. Tax-saving funds can be considered depending on your age. If you are over 55 years old you may want to reduce allocations to tax-saving funds. Maintain a good mix of NSC and PPF to ensure that you can benefit from interest rate movements either ways.

Infrastructure bonds can be ignored. Pay the tax instead and invest in diversified equity funds, balanced funds or even MIPs depending on your risk profile. Consider taking a property on a loan. You will get tax benefits on the loan for creating an asset that can generate revenues for you going forward.