'Mutual funds' - A generation of investors has grown up listening to these words. While mutual fund returns are one of the prime factors that attract investors, they also get a few tax benefits that add to the mutual funds' attraction. However, given the multiple changes in mutual fund taxation in past budgets, let us take a comprehensive review of mutual fund taxation to make informed investment decisions. Check out this blog to learn all about the taxation of mutual funds and how recent changes have impacted investors. 

Taxable Returns from Mutual Funds

Before we move on to the taxation of mutual funds, let us focus on the various forms of returns (income or gains) from mutual funds. 

Dividend Income and Interest Income 

Mutual funds invest in a diverse pool of assets that include stocks, debt, and investing in gold, etc. These assets can generate income in the form of dividends from stocks or interest income from debt instruments. 

Dividends provide an additional income stream for mutual fund investors and are paid from the fund's accumulated distributable surplus. These payouts occur at the fund’s discretion and are therefore not considered to be a stable or fixed source of income. Furthermore, prior to the Amendment in Finance Bill 2020, dividends received from mutual funds were tax-free in the hands of the investors. However, after the amendment, they are included in the taxable income of the investors and taxed at applicable slab rates.

Interest income, on the other hand, is considered to be a more stable or regular source of income as debt instruments give interest on the investment at set intervals which is declared at the time of issuing the instrument. This interest income too is taxable in the hands of the investors at applicable slab rates. Certain debt funds also invest in tax-free bonds or similar debt instruments where the interest received on such instruments is not taxable for investors and thus provides tax benefits. 

Capital gains 

The other form of returns from mutual funds is the capital gains received from the sale of units of the fund. The amount in excess of the purchase price of the units of the fund is considered to be capital gains which are taxable in the hands of the investors based on two important factors, namely, the type of fund and the period of holding of the units. Similarly, capital loss (which is the loss incurred on the sale of the units of the fund) can be set off and carried forward for a period of 8 years provided they are duly filed in the Income Tax Return. 

How are Mutual Funds Taxed?

The recent changes to the Income Tax Act, 1961 in the Budget of 2024 have revised the capital gains taxation on dual aspects, i.e., the applicable tax rates and the tenure for capital gains calculation. Here is a detailed explanation of the mutual funds taxation for the three primary categories of mutual funds based on the type of asset they invest in.  

Equity Mutual Funds

Equity Mutual funds invest primarily in Indian stocks or equities and equity-related instruments, i.e., a minimum of 65% of the fund corpus. These funds are further classified into various types based on the equities they invest in and the scheme objective, for example, Large-Cap funds, Mid-Cap funds, ELSS (tax saving funds), Flexi-Cap funds, Sectoral Funds, Value Funds, etc. 

As mentioned above, Budget 2024 amended the tax rates for equity mutual funds as well as the minimum exemption limit available for capital gains on the sale of units of equity mutual funds. The details of the same are tabled hereunder.

Debt Mutual Funds

Debt mutual funds invest primarily (at least 65% of the corpus) in a variety of debt instruments like government bonds, treasury bills, commercial papers, corporate bonds, etc. Some of the classic examples of these funds include gilt funds, corporate funds, floater funds, liquid funds, and more. 

Before Budget 2023, debt mutual funds in India were taxed based on the duration they were held by the investors. Gains from units held for less than 3 years were considered short-term and taxed at the investor's income tax rate, while gains from units held for over 3 years were taxed at a lower long-term rate of 20% with the benefit of indexation. This benefit allowed investors to adjust the purchase price for inflation thereby lowering their net taxable amount on long-term gains.

Budget 2023 created a special category for debt mutual funds that invested more than 65% in debt instruments and took away the benefit of long-term capital gains tax rates. Gains from these funds are now taxed at the applicable slab rates of investors irrespective of the holding period and no indexation benefits. 

Budget 2024 further simplified the rules for all funds lowering the holding period for long-term gains from 3 years to 2 years. Furthermore, the long-term gains are now taxed at a flat 12.5% without indexation benefit. However, the specified debt funds from Budget 2023 (those with over 65% in debt) will still be taxed at the applicable slab rates of investors irrespective of the holding period. 

These changes were introduced to simplify the taxation process and make it more equitable for investors. However, they have also impacted the attractiveness of debt mutual funds as an investment option compared to other financial instruments by bringing them at par with similar and traditional fixed-income investment options like fixed deposits.

Here is a summary of the debt mutual fund taxation as per the latest applicable rules. 

Hybrid Mutual Funds 

Funds that invest in a mix of debt and equity instruments between 35% and 65% of the fund corpus are classified as hybrid mutual funds. These funds aim to balance the risk and return from equity and debt funds, thereby providing maximum benefits to investors of both types of investment options. The types of hybrid mutual funds include conservative funds, balanced funds, arbitrage funds, aggressive hybrid funds, etc.

The taxation of these funds depends on their asset allocation. If the fund has a higher investment in equity instruments, it is classified as an equity-oriented hybrid fund and taxed like equity mutual funds. Similarly, hybrid funds with a higher investment in debt instruments are classified as debt-oriented hybrid funds and taxed like debt funds. 

The summary of taxation for hybrid mutual funds is tabled below.

Conclusion

The taxation of mutual funds has undergone significant changes in the past couple of years. These amendments in the rate of taxation and reduction in the holding period are an attempt to make the process simpler and more uniform across fund categories. However, the changes in mutual fund taxation have made certain categories less attractive, especially with the withdrawal of the indexation benefit. Therefore, investors have to understand these changes effectively and how they will impact their investment decisions to make informed decisions and ultimately have a profitable portfolio. 

This topic talks about the latest changes in the mutual fund taxation arena and how they have impacted investors. What do you think of these changes? Are they a welcome change for you or not? Let us know your thoughts on this topic or any queries that you have and we will address them. 

Till then Happy Reading!

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