Taxation — what the investor actually keeps

Two levels of income, one of them tax-free

A mutual fund is a pass-through vehicle, so tax has to be looked at twice: income earned by the fund, and income earned by the investor.

The fund's income is exempt. Because mutual funds are constituted as trusts in India for the benefit of unitholders, Section 10(23)(D) of the Income Tax Act exempts all income earned by mutual fund schemes from any tax.

That is the answer to one of the most frequently asked questions in this exam, and it is also the foundation of everything else in the chapter. The fund pays nothing. You pay — but only when income actually reaches you.

What decides your tax rate

Six variables, and the exam tests every one:

• Type of income — capital gains are taxed differently from IDCW (dividend)
• Holding period — short term or long term
• Type of scheme — equity-oriented or not
• Type of investor — resident, NRI, non-individual. In joint holding, income is treated as earned by the first holder
• Date of purchase — Budget 2023 changes applied from 1 April 2023; earlier investments kept the old structure
• Date of redemption — Budget 2024-25 changes took effect 23 July 2024. Units redeemed before that date use the old rates; on or after, the new rates

The tax definition of "equity-oriented" is not the SEBI one

This trips people up constantly.

So a fund of funds investing in equity mutual funds is non-equity-oriented for tax — even though the money ultimately reaches equity — because it holds units, not listed shares.

Keep this separate from the TER definition in Chapter 7, which uses 65% in equity and equity related instruments per the SID. Same number, different test, different purpose.

Capital gains

Sell units above your purchase price and you have a capital gain; below, a capital loss.

There are only two holding periods now: 12 months and 24 months. Twelve months for all listed securities and units of equity-oriented funds; 24 months for all other assets.

The rates

Note what happened to debt funds: there is no long-term concession at all — gains are taxed at your marginal slab rate regardless of holding period. For someone in the 30% bracket, that is a significant change from the old regime.

The ₹1.25 lakh exemption

For long-term capital gains from equity shares and equity-oriented mutual funds, tax applies only above ₹1.25 lakh in a financial year.

Earn ₹90,000 of LTCG and the whole amount is exempt. Earn ₹1,35,000 and the first ₹1,25,000 is exempt while ₹10,000 is taxed.

This is genuinely useful advice to give a client: harvesting gains up to ₹1.25 lakh each year costs nothing in tax, and resets the acquisition cost higher.

Grandfathering — 31 January 2018

Long-term capital gains on equity were exempt until the Union Budget of 2018. Taxing gains that had already accrued would have been retrospective taxation, so the finance minister introduced grandfathering.

The workbook's illustration: ₹1,00,000 invested in 2017, worth ₹2,00,000 on 31 January 2018.

• Sell for ₹1,80,000 → LTCG is treated as zero, since the realised value is below the 31 January 2018 value
• Sell for ₹2,20,000 → LTCG is ₹20,000, the excess over the 31 January 2018 value

The pre-2018 appreciation of ₹1,00,000 is never taxed. That is what grandfathering means.

IDCW — dividend income

The history matters because the exam asks about the change.

Until 2019-20: dividend was tax-free in the hands of the investor, but the scheme paid Dividend Distribution Tax (DDT) before paying you. So it was never really free — the NAV fell by the dividend plus the DDT.

From April 2020: DDT was abolished. IDCW is now added to your taxable income and taxed at your marginal slab rate.

Who won and who lost:

• High earners lost. They previously paid DDT at a flat rate below their marginal rate; now they pay their full slab rate
• Tax-exempt investors won. Charitable trusts and individuals in the exempt slab used to bear DDT invisibly. Now dividend income is genuinely tax-exempt for them

There is one further difference worth knowing: DDT was not a tax in the investor's hands, so it could not be set off against any other tax liability. Tax on dividends under the new regime can be reduced through exemptions and adjustments.

What stayed the same: under both regimes, the NAV falls by more than the net amount you receive.

• Old: Drop in NAV = dividend paid + DDT
• New: Post-tax dividend = dividend paid out − tax at your slab rate (except for tax-exempt holders)

Why growth is usually the better option

Because the scheme itself is tax-exempt and capital gains are realised only when you book them, choosing growth lets gains run without an annual tax drag.

Money that would have gone to the tax department each year stays invested and keeps earning. Over long periods that difference is substantial, and it is the strongest argument for recommending growth over IDCW to a client who does not need regular income.

From 1 April 2021, funds declaring dividend must indicate how much is income distribution due to NAV appreciation and how much is capital distribution — investors previously taxed the entire amount as dividend, and must now compute on that segregated basis.

Stamp duty

From 1 July 2020, following amendments to the Indian Stamp Act in February 2019:

It applies to all scheme inflows: purchase, additional purchase, dividend reinvestment, SIP, STP, and IDCW (Dividend) Transfer Plan — including triggers from past SIP/STP registrations. It applies to both physical (SoA) and demat units, and units are allotted for the amount available after deducting stamp duty.

Setting off gains and losses

The general rules under the Income Tax Act:

• Capital loss — short term or long term — cannot be set off against any other head of income (salary, house property, business, other sources)
• Short term capital loss can be set off against short term capital gain OR long-term capital gain
• Long term capital loss can only be set off against long term capital gain
• Unabsorbed capital loss can be carried forward up to 8 years

The asymmetry is the point: short-term loss is more flexible than long-term loss. A short-term loss can absorb either kind of gain; a long-term loss can only absorb long-term gain.

Bonus stripping

A scheme's units are bought at ₹30. The scheme declares a 1:1 bonus, so the investor gets one extra unit free and the NAV roughly halves to ₹15. Selling the original unit at ₹15 books a loss of ₹15 — while still holding a bonus unit worth ₹15.

That would be a manufactured loss, so the law blocks it:

In such cases, the loss is treated as the cost of acquisition of the bonus units — so it is not lost, merely deferred until the bonus units are sold.

The workbook adds a sensible line: even where the timing conditions are met, the practice is discouraged. Investments should be made for the fundamental attributes of the scheme, not to engineer a tax loss.

Securities Transaction Tax

STT applies only on the sale side, and only for equity-oriented mutual funds.

STT is not applicable on purchase of units, and not applicable to debt securities or debt mutual fund schemes at all.

It applies on redemption, switch to other schemes, or sale of units of equity-oriented funds — whether on a stock exchange or otherwise.

A practical consequence: a switch out of an equity fund attracts STT, because a switch is a redemption followed by a purchase.

Section 80C and ELSS

ELSS (Equity Linked Savings Scheme) qualifies for deduction under Section 80C — but only under the Old Tax Regime.

• Benefit up to ₹1.50 lakh per year per taxpayer, for individuals and HUFs
• Lock-in of three years from the date of investment

Four nuances that carry marks:

1. The ₹1.5 lakh limit is shared across all eligible 80C avenues. If you have exhausted it elsewhere, an ELSS investment gets no additional deduction — but is still locked in for three years.

2. With a SIP, each instalment is locked in from its own date. The whole amount does not unlock three years after the first instalment. A client starting a monthly ELSS SIP in April 2026 finds the April instalment free in April 2029 and the March 2027 instalment free only in March 2030.

3. Dividend reinvestment triggers a fresh 3-year lock-in each time. Most AMCs have therefore removed that option for ELSS, offering only growth or dividend payout.

4. In joint holding, the benefit goes to the first holder.

Under the New Tax Regime announced in Budget 2020 — more slabs, lower rates, most exemptions removed — there is no Section 80C benefit. For such investors, ELSS is simply an equity-oriented scheme that happens to carry a lock-in, which is a genuinely important thing to explain before selling one.

Some retirement-oriented funds also carry Section 80C benefit, with a 5-year lock-in — but not all of them do, so check the specific fund.

TDS

• No TDS on re-purchase (redemption) proceeds to resident investors
• TDS does apply to certain non-resident investments, at rates varying by investor type, investment type and income type
• On dividends (IDCW), TDS applies even for resident Indians — at 10% where the dividend exceeds ₹5,000

For non-residents, India's Double Taxation Avoidance Agreements (DTAA) specify withholding rates. The applicable TDS is the lower of the income tax rate or the DTAA rate of the investor's country of residence — provided the investor supplies sufficient information and documents to establish entitlement.

GST on the scheme

GST on distributor commission cannot be charged to the scheme — it is the ARN holder's own liability.

From 1 April 2026, the cost structure is base expense ratio + execution brokerage within specified limits + statutory levies such as GST, and no charges other than base expense ratio, brokerage cost, transaction cost, statutory levy and exit load may be charged to investors.