Taxation — capital gains, IDCW, STT, stamp duty and Section 80C

Where this chapter sits

Chapter 8 carries 6% of the paper. It is entirely rules and rates, and the rates changed twice in recent years — so the dates matter as much as the numbers.

Three things dominate: the capital gains table, the ₹1.25 lakh exemption with grandfathering, and STT applying only to equity-oriented funds on the sell side.

8.1 Two levels of income

As a mutual fund is a pass-through vehicle, we must consider the income at two levels– income earned by the fund, and income earned by the investor.

Income earned by the scheme — exempt

The schemes of the mutual funds invest in marketable securities like shares and debentures. These securities generate income in the form of dividend or interest. Apart from this, when the fund buys and sells the shares and debentures in the securities market, there could be capital gains or losses. Interest, dividend and capital gains form the income of the mutual fund.

And then the key rule: as per the prevailing tax laws in India, a mutual fund's income is exempt from income tax, since mutual funds are constituted as trusts in India for the benefits of the unitholders. Section 10(23)(D) of the Income Tax Act exempts all the income earned by the mutual fund schemes from any tax.

Section 10(23)(D). Learn the number — the workbook asks this directly.

Income earned by the investor

The one who has opted for Income distribution cum capital withdrawal (dividend) may get income in form of dividends, whereas the investor in the growth plan would not get any dividend whatsoever, irrespective of the profits earned by the fund.

The investor in the growth plan would earn capital gains (or losses) whenever one sells the units of the scheme. On the other hand, the investor in the Income Distribution cum capital withdrawal (dividend) plan may get dividend, as and when declared by the fund, as well as capital gains (or losses) when one sells the units.

The six factors determining tax

Type of income — the capital gains are taxed differently in comparison to the dividend income (IDCW).

Holding period — capital gains may be categorized as short term and long term based on the holding period. At the same time, within capital gains, short term capital gains may attract different tax rates in comparison to long term capital gains.

Type of mutual fund scheme — the Income Tax Act defines two categories of mutual funds, viz., equity-oriented funds and non-equity-oriented funds. The schemes holding more than 65 percent of the assets under management in equity shares listed on recognised stock exchanges in India are classified as equity-oriented mutual fund schemes. All the other schemes are classified as non-equity-oriented schemes.

And a trap worth marking: for example, fund-of-funds investing in other equity mutual fund schemes, would be classified as non-equity-oriented schemes. Though the said scheme is eventually investing in equity assets (equity mutual funds), it is classified as a non-equity-oriented scheme for the purpose of income tax.

Type of investor — the tax treatment may differ for Resident Indian Investors, NRIs, and non-individual investors. And note: in case of joint holding, the income, be it capital gains or dividend, would be considered to have been earned by the first holder.

Date of purchase — the union budget 2023 brought some changes in the taxation of capital gains. These changes were applicable from April 1, 2023 onwards. Investments made prior to that date, i.e., April 1, 2023 would enjoy the old tax structure.

Date of redemption — if the units are redeemed before July 23, 2024, the old tax rates would apply. The new tax rates would be applicable for units redeemed on or after July 23, 2024.

Two dates, two different triggers. 1 April 2023 turns on when you bought; 23 July 2024 turns on when you sold.

8.2 Capital gains

When a unitholder sells units of the scheme, the selling price could be different from the price at which the units were bought. The difference between the purchase price of the units and the selling price of the units would be treated as capital gain (or loss).

Capital gains tax is classified depending on the period of holding and the type of funds invested in.

The two holding periods

For classifying assets into long-term and short-term, there will only be two holding periods: 12 months and 24 months.

The holding period for all listed securities as well as for units of equity-oriented funds is 12 months. The holding period for all other assets is 24 months.

Only two numbers now — 12 and 24 months.

The rate table

Two rows carry MSR for both short and long term — debt-oriented funds and debt ETFs. For them the distinction between short and long simply does not arise.

Only equity-oriented funds carry a 20% STCG. Everything else short-term is at the marginal slab rate.

And 12.50% is the LTCG rate for every category that has one.

Grandfathering

Equity mutual funds were exempt from long term capital gains tax earlier. In the Union Budget of the year 2018, this was changed. Starting April 2018, long term capital gains became taxable.

The problem that created: since the capital gains from equity assets were non-taxable till the announcement of the budget in 2018, an introduction of the tax would have meant that even the gains earned till then would also become taxable. This is equivalent to introducing tax with retrospective effect.

The solution: the finance minister introduced a clause, which came to be known as the "grandfathering of the capital gains". This meant that the capital gains earned till January 31, 2018 would not be taxable, which means that for all the equity mutual funds that one has invested in, the valuation as on January 31, 2018 becomes the base point.

The rule for computing the gain: gains would be calculated for the purpose of tax by taking the higher of the purchase price or the NAV as on January 31, 2018.

Higher of the two — that is the whole mechanism.

The workbook's two scenarios, on ₹1,00,000 invested in 2017 with a value of ₹2,00,000 on January 31, 2018:

Scenario 1 — sold for ₹1,80,000 on 9 February 2018: the long-term capital gains for the purpose of taxes would be considered to be zero, since the realized value is less than the value of investments on January 31, 2018.

Scenario 2 — sold for ₹2,20,000: the long-term capital gains for the purpose of taxation would be considered to be Rs. 20,000 (The difference between the realised value of Rs. 2,20,000 and the value on January 31, 2018 – Rs. 2,00,000).

Note that in scenario 2 the actual gain over cost was ₹1,20,000, but only ₹20,000 is taxable. The rest accrued before the tax existed.

The ₹1.25 lakh exemption

In case of long-term capital gains arising out of equity shares and equity-oriented mutual funds, the tax is applicable only on the capital gains above Rs. 1.25 lakhs. The first Rs. 1.25 lakhs worth of long-term capital gain from this category is tax-exempt.

And it is per financial year, as the rate table records.

The workbook's illustration: if an investor has earned a total long term capital gain worth Rs. 90,000 in a year, the entire capital gain would be exempt from tax. On the other hand, if the total capital gain is Rs. 1,35,000; the first Rs. 1,25,000 would be exempt from capital gains tax, but the next Rs. 10,000 would be subject to tax.

8.3 Income Distribution cum Capital Withdrawal

The old regime

Dividend income from mutual funds used to be tax-free in the hands of the investor. There was no tax payable at all, irrespective of how much dividend one earned.

But it was not really free: the dividend would be paid to the investor after the deduction of dividend distribution tax from the scheme itself. To that extent, although the dividend was tax-free, the NAV reduced to the extent of the dividend as well as the dividend distribution tax. Thus, this tax had an impact on the investor's after-tax returns.

The new regime

In the Union Budget presented by the finance minister in February 2020, the situation changed. The dividend distribution tax has been done away with, whereas the dividend would henceforth be added to the taxable income of the assessee for the year. This means the dividends would be taxable in the hands of the recipient at the applicable tax rate.

Who gained and who lost:

In the new regime, tax on dividend would be a function of the applicable rate of tax based on the total income for the year, and hence the tax rate goes up for those with higher income. This means those who were in higher tax earlier might have paid a lower tax on the dividend income in comparison to their nominal rate of tax. This difference goes away.

On the other hand, the investors, who were tax-exempt also had to still bear the impact of the dividend distribution tax in the earlier regime. Now with the changes proposed, the dividend income would be tax exempt for investors in various tax-exempt categories, for example charitable trusts, mutual fund schemes and individuals in the tax-exempt slab.

High earners lost; tax-exempt investors gained.

And one important structural difference: the dividend distribution tax was not considered a tax in the hands of the investor, and hence it was not available as a set-off against any other tax liability. On the other hand, in the new regime, tax on dividends can be reduced through various exemptions and adjustments, as applicable.

Also to note: the NAV of the scheme goes down more than the amount received in the hands of the investor.

Why growth is more tax-efficient

On the other hand, the growth option works out to be more tax-efficient. Since the mutual fund schemes are tax-exempt, and the capital gains are realized only when booked, one can allow the gains to run without worrying about tax on the same. This concept is known as deferment of taxes and allows one the benefit of compounding before tax.

Deferment of taxes — the benefit of compounding before tax. That phrase is the argument for growth over IDCW in one line.

8.4 Stamp duty

With effect from July 1, 2020, mutual fund units issued against Purchase transactions (whether through lump-sum investments or SIP or STP or switch-ins or Reinvestment of Income distribution cum capital withdrawal) would be subject to levy of stamp duty @ 0.005% of the amount invested.

Transfer of mutual fund units (such as transfers between demat accounts) is subject to payment of stamp duty @ 0.015%.

Issue 0.005%; transfer 0.015%. Three times higher on transfer.

The mechanics: stamp duty @0.005% of the investment amount shall be applicable at the time of issue of units for both physical and demat units. And units will be allotted for the amount available post deduction of stamp duty.

What it applies to — all transactions pertaining to scheme inflows:

Purchase · Additional Purchase · Reinvestment of Income distribution cum capital withdrawal · Systematic Investment Plan (SIP) · Systematic Transfer Plan (STP) · Income distribution cum capital withdrawal (Dividend) Transfer Plan (DTP).

This will also include triggers from past SIP/STP registrations.

It arises from the amendments carried out in the Indian Stamp Act in February 2019, effective 1 July 2020.

8.5 Setting off gains and losses

The Income Tax Act provides for taxation under various heads of income viz. salaries, income from house property, profits & gains of business or profession, capital gains, and income from other sources.

One might expect free adjustment across heads, but: there are limitations to such set-off.

The four rules:

• Capital loss, short term or long term, cannot be set off against any other head of income (e.g., salaries)
• Short term capital loss is to 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 upto 8 years

Note the asymmetry. A short term loss can absorb either kind of gain; a long term loss can absorb only long term gain.

8.6 Securities Transaction Tax

When an investor sells units of an equity fund in the stock exchange, or offers them for re-purchase to the fund, he will have to incur Securities Transaction Tax (STT) i.e., STT is applicable only on redemption/switch to other schemes/sale of units of equity oriented mutual funds whether sold on stock exchange or otherwise.

Two exclusions to remember: STT is not applicable on purchase of units of an equity scheme. It is also not applicable to transactions in debt securities or debt mutual fund schemes.

Always the seller, never the purchaser — and never on a debt fund.

8.7 Section 80C and ELSS

Certain mutual fund schemes, known as Equity Linked Savings Schemes (ELSS) are eligible for deduction under Section 80C of the Income Tax Act under the old tax regime.

The benefit is available up to Rs. 1.50 lacs per year per taxpayer in case of individuals and HUFs. The scheme has a lock-in period of three years from the date of investment.

₹1.50 lakh, three years, individuals and HUFs, old regime only.

Four nuances

First — this is one of the eligible investments under Section 80C, where the limit is to be shared across the eligible avenues. This means if someone has exhausted the limit under the said section through some other avenue, any investment in ELSS would not get any additional tax exemption, but the investment would still be locked-in for a minimum period of three years.

The lock-in applies whether or not you get the deduction. That is the trap.

Second — if one is investing in this scheme through SIP, each investment would be locked-in from the date of the respective investment. The lock-in for the entire amount would not get over on completion of 3 years from the date of the first SIP instalment.

Third — if one opts for (dividend) Income distribution cum capital withdrawal reinvestment plan, each time a dividend is reinvested, the same would also attract a 3-year lock-in. Most AMCs have done away with this option in case of ELSS. They only allow growth option or dividend pay-out.

Fourth — the tax benefit would be available to the first holder, in case of a joint holding.

Old regime versus new

The finance minister, in the Union Budget 2020, proposed two parallel tax structures for the individual taxpayers. The old one allowed different kinds of exemptions and deductions under various sections of the Income Tax Act. The new one has more slabs, and lower rates of taxes for similar slabs. However, under the new regime, most exemptions have been removed.

And the consequence for ELSS: those who opt for this new structure would not be able to take the benefit of tax-saving under Section 80C. Hence, for these investors, ELSS is just another equity-oriented mutual fund scheme that carries a lock-in provision.

All of the lock-in, none of the benefit.

8.8 Tax Deducted at Source

There is no TDS on re-purchase proceeds to resident investors. However, for certain cases of non-resident investments, the same is applicable.

What determines the rate: the income tax regulations prescribe different rates, depending on the nature of the investor (Indian/Foreign and Individual/Institutional), nature of investment (equity/debt) and nature of the income (dividend/capital gain).

One case where residents do face TDS: in case of dividends (IDCW) from mutual fund schemes, even for resident Indians, TDS is applicable. The tax is required to be deducted at 10 percent on the dividend amount if it exceeds Rs. 5,000.

10 percent, above ₹5,000.

For non-residents: Government of India has entered into Double Taxation Avoidance Agreements (DTAA) with several countries. These agreements too, specify rates for Withholding Tax.

The TDS applicable for non-resident investors is the lower of the rate specified in the income tax regulations or the tax specified in the DTAA of the country where the investor is resident.

But the benefit must be claimed: the investor, however, will need to provide sufficient information and documents to satisfy the mutual fund that he is entitled to such concessional rate as is specified in the DTAA.

8.9 GST

AMC(s) can charge GST, as per applicable Taxation Laws, to the schemes within the limits prescribed under SEBI (Mutual Fund) Regulations.

Where GST sits relative to the expense ratio:

• GST on fees paid on investment management and advisory fees shall be charged to the scheme in addition to the overall limits specified as per the Total Expense Ratio (TER) provisions
• GST on all the fees other than investment and advisory fees shall be charged to the scheme within the maximum limit of TER
• GST on exit load, if any, shall be deducted from the exit load and the net amount shall be credited to the scheme
• GST on brokerage and transaction cost paid for execution of trade, if any, shall be within the limit of TER

Note the split — GST on investment management and advisory fees is in addition to the TER; GST on all other fees is within it.

On distributor commission: the commission payable to the distributors of mutual funds may be subject to GST, as applicable in case of the ARN holder. Such tax cannot be charged to the scheme.

The new cost structure: as per SEBI regulations from 1 April 2026, the cost structure is base expense ratio + execution brokerage with specified limits + statutory levies e.g. GST.

The base expense ratio of the scheme shall be sum of expenses allowed i.e. investment and advisory fees, out-of-pocket expenses and brokerage commission but excluding statutory levy applicable, if any, on the said expenses and transaction cost.

And a closing prohibition: no charges other than the base expense ratio, brokerage cost, transaction cost, statutory levy and exit load including levies as may be specified by the Board, shall be charged to the investors.