Startup Taxation

Taxation of Mutual Funds in India

Mutual funds are investment pooling entities that pool the capital of different investors and invest the money in a variety of investment options such as company stocks, bonds, shares etc. Securities and Exchange Board of India (SEBI) regulates mutual funds in India. Investing in mutual funds is considered as the easiest way of increasing wealth. A mutual fund can be viewed as both an investment and an actual company. Here it needs to be noted that returns gained from mutual fund investments are liable for taxation. The returns are taxed under ‘Income from Capital Gains’ header. In this text, you will get a complete understanding of taxation of mutual funds in India.

Types of Mutual Funds

Mutual funds in India are classified into different categories based on their structure, investment objectives and risk.

Mutual Funds based on their structure

Open-ended funds: These type of mutual funds does not have a fixed maturity period. Such mutual funds have no restrictions as far as the number of units that can be traded or the time period is concerned.

Closed-ended funds: The maturity period of these mutual funds is fixed. The capital that is to be invested in close-ended mutual funds is fixed beforehand, and hence it is not viable to sell more than the pre-agreed number of units. Such funds have relatively low liquidity.

Mutual Funds based on nature of investments

Equity funds: Equity funds are the most preferred investment options among the investors. These types of funds generally make investments in stocks of companies. Though equity funds are categorized as high risk, these funds also have a potential of high returns. Historically equity funds have outperformed all asset classes in the long term. The return from equity funds depends upon the performance of shares in stock market.

Debt funds: These type of funds aim at generating regular income for investors by investing in bonds, corporate debentures etc with fixed interest rate and maturity date. Investors looking for a small but regular income with minimal risks should invest in these funds.

Money Market Funds: Investors typically use these types of funds to invest in high quality, short-term debt instruments, cash and cash equivalents. These funds are considered extremely low risk on the investment spectrum.

Different Types of Mutual Funds

Mutual Funds based on Asset Class	Mutual Funds based on Structure	Mutual Funds based on Investment Objectives	Mutual Funds based on Risk Profile
Equity Funds	Open-ended Mutual Funds	Growth Funds	High-risk Funds
Debt Funds	Closed-ended Mutual Funds	Income Funds	Medium-risk Funds
Money Market Funds	Interval Funds	Liquid Funds	Low-risk Funds
Hybrid or Balanced Funds		Tax-saving Funds	Very Low-risk Funds
		Aggressive Growth Funds
		Pension Funds
		Fixed Maturity Funds

Taxation of Mutual Funds

Investors having a mutual fund portfolio should have good understanding of how the taxes of mutual funds are returned. Mutual funds provide earnings in two forms i.e. Capital Gains and Dividends. The profit made on mutual fund investments when the units are redeemed or sold is referred to as capital gains. These capital gains of mutual funds are taxable at the hands of investors. On the other hand the dividend options of mutual funds known as Dividend distribution Tax (DDT) is paid by the Asset Management Company on behalf of the investors.Taxation of Mutual Funds Capital Gains

A capital gain is a difference between the value at which the investor purchased the units of a mutual fund scheme and the value at which he sold them. Taxation of mutual funds on capital gains depends upon the type of mutual fund schemes and the period of investment.

Capital Gains Tax are further divided into two types based on the time period of investment, following are the two types of Capital Gains Tax:

Short Term Capital Gains Tax (STCG): Short Term Capital Gains are derived from an asset owned for a year or less. The tax levied on short term capital gain is more than as compared to the tax levied on Long term Capital Gains. Short term capital gains are taxed as regular income.

Long Term Capital Gains Tax (LTCG): Long Term Capital Gains are derived from investments that were held for more than a year. Tax levied on Long term capital gains is less as compared to the tax levied on Short Term Capital Gains. These gains are subject to more favorable tax rates of 0%, 15% and 20%.

Taxation of Mutual Funds Dividends

Dividend Distribution Tax (DDT): This type of tax is deducted and paid by the Asset Management Company before paying any dividend to investors. Therefore, investors don’t have to pay any tax on dividends earned on a mutual fund scheme.

Type of Scheme	Dividend Distribution Tax Rate
Equity oriented scheme	10%+12%surcharge+4%Cess
Non-equity oriented Scheme	25%+12%surcharge+4%Cess

Conclusion

From the above given points we are able to reach a conclusion that holding on to mutual fund units for a longer period of time is more tax efficient. On the other hand, the tax levied on short term capital gains is comparatively more, and these gains are taxed as regular income.

Suggested Reads: How does a mutual fund operate in India

Registration of Mutual Funds with SEBI