Article explains about Income Tax on Income distributed to Unit Holders by Mutual Funds (Detailed analysis with amendments made by Finance Act, 2020 and with illustrations on pre and post budget 2020 changes).
India has plethora of investment instruments which are available, for an investor, to park his idle funds. At times, it becomes really difficult for a person to select one such instrument, which would reap him good gains.
An investor is thus provided with 2 investment options – a direct route and an indirect route.
Under the direct route, the investor himself invests in specific securities on the basis of his own research, fundamental and/or technical understanding, knowledge, experience, fair vision, etc.
For example, Mr. A, finds the future of a company XYZ, which is involved in the business of manufacturing customized hand made goods, very lucrative and radiant, after carefully examining its operations and financials. He makes up his mind to invest his idle funds in this particular company and thus, buys say, 1000 shares of this company at Rs. 250 per share thereby investing Rs. 2,50,000.
This is a case of direct investment, where Mr. A after his own research, etc. invests directly in company XYZ by purchasing its shares from the open market [i.e. stock exchange (BSE/NSE)].
A person cannot be a master of every field. He or she may possess very sound knowledge on various other aspects but when it comes to investment, they make mistakes! They are not well versed with the fundamental and technical aspects and their investments most often end up reaping low returns or losses instead. Thus, there was an immense need for an alternative route for investing and to cater the same; the indirect route came on to the front.
Under the indirect route, the investor invests his money with a Fund and gets back, against his invested money, the units of such Fund. The Fund, which employs highly educated and experienced people, park the corpus, so collected, into various instruments/securities. When these investments, so made by the Fund, make profit/gains/appreciations, they are passed on to the investors using whose money, such investment was initially made by the Fund. These Funds, which collect money from various investors and then invest the same across various instruments/securities etc., with the application of expert knowledge and experience, are known as MUTUAL FUNDS.
For example, Mr. A has a surplus fund of Rs. 2,50,000. He is unaware as to where he should park his fund. He approaches a Mutual Fund XZ. The Mutual Fund informs Mr. A that they have 2 schemes available for its investors. Under the 1st scheme, the entire fund is parked into equity instruments i.e. into shares and securities of various companies, etc. (all equity scheme) and in the 2nd scheme, 80% amount is parked into equity and the balance 20% is parked into money market instruments i.e. commercial papers, bills of exchange, treasury bills, etc. (hybrid scheme). Mr. A, say, aged around 40 years, can take afford to take risk as he has fixed source of income and thus decides to opt in for the 1st Scheme i.e. all equity scheme. The mutual fund shall now give units worth Rs. 2,50,000/- to Mr. A of the 1st scheme – All Equity Scheme, say, 2500 units at a price of Rs. 100 each (known as Net Asset Value or NAV). The mutual fund employs highly skilled and experienced people who (under the supervision of a Fund Manager), shall now invest the collected corpus into various securities and instruments under equity segment. The investment so made, by the Mutual Fund, reaps income by way of dividend/interest and capital appreciation which is passed on to the unit holders of the Mutual Fund. This way the unit holders indirectly, through Mutual Funds, invest and reap rewards.
In our earlier article which was on the topic Dividends – No Longer Tax Exempt, we talked about the tax implications (pre and post budget 2020) that would accrue to Mr. A (person in our above example) when he invests under the direct route.
In this article we shall focus upon the tax implications (pre and post budget 2020) on the income earned by Mr. A when he invests under the indirect route i.e. in Mutual Funds.
THE PRE – BUDGET 2020 SCENARIO
Section 115-R of the Act, provides that, any amount of income (by way of interest/dividend) distributed by the a Mutual Fund to its unit holders shall be chargeable to tax and such Mutual Fund shall be liable to pay additional income-tax on such distributed income at the rate of :
|NAME / TYPE OF FUND||Individual or Hindu Undivided Family (HUF)||Any other person|
|1.||Equity Oriented Mutual Fund
(made taxable by The Finance Act, 2018)
|2.||Any other Fund
(except a Mutual Fund under an Infrastructure Debt Fund Scheme)
|3.||Mutual Fund under an Infrastructure Debt Fund Scheme||Resident||Non – Resident or a Foreign Company|
|Individual or HUF||Any other person|
|25%||30%||5% (made by the Finance Act, 2013)|
Note: The above rates shall be increased by surcharge and health & education cess, as applicable.
[ Section 115-R(2A) provides that the amount of distributed income, referred above, shall be grossed up or increased to such an amount that after the reduction of additional income-tax on such grossed up amount, the resultant figure is the amount of income distributed by the Mutual Fund.
So, if the income of Rs. 100 is to be distributed, then Rs. 100
– shall be increased to such an amount;
– as would after reduction of tax on such increased amount;
– @10%/25%/30%/5%, as applicable;
– would be equal to income of Rs. 100, so distributed.
Therefore, if the dividend is Rs. 100, then
100 x [100% ÷ 90%] = 111.11111
100 x [100% ÷ 75%] = 133.33333
100 x [100% ÷ 70%] = 142.85714
100 x [100% ÷ 95%] = 105.26316
The rates shall be increased by surcharge of 12% and health and education cess of 4%. Therefore the effective rates of tax after grossing up shall be :
In place of 10% – 12.942%
In place of 25% – 38.826%
In place of 30% – 49.92%
In place of 5% – 6.131% ]
The income, so distributed, by any mutual fund (by way of dividend or interest) is exempt in the hands of unit holders by virtue of Section 10(35) of the Act.
Also, all incomes of all the mutual funds are exempt from tax by virtue of Section 10(23D).
Let’s now understand the pre-budget status in the hands of an individual through an illustration.
Facts: Mr. A invests Rs. 2,50,000 in an Equity Oriented Mutual Fund and gets 2500 units at an NAV of Rs. 100 per unit. The fund distributes income in the form of dividend to its unit holders of Rs. 1,00,00,000.
|Tax Implications in the hands of the|
|Mutual Fund||Unit Holder i.e. Mr. A|
|Pay tax of Rs. 12,94,200* (approx.)
*(@12.942% on Rs. 1,00,00,000 being the income distributed by way of dividends to its unit holders)
|NIL** tax payable
**Exempt by virtue of Section 10(35)
Thus, the Mutual Fund was liable to deposit Rs. 12,94,200 (approx.) as tax on distribution of income, by way of dividends, to the unit holders. The unit holders, however, are not subject to any tax by virtue of applicable provisions.
It is pertinent to note here that the provisions above are similar to those were applicable in case of income declared, distributed or paid in form of dividends by a domestic company to its shareholders. The company was liable to pay Dividend Distribution Tax under section 115-O and the dividend so received was not taxed in the hands of the shareholders.
The provisions are, in essence, very similar.
THE POST – BUDGET 2020 SCENERIO
Currently in the case of income distributed by the mutual funds, the incidence of tax is on the payer i.e. on the mutual fund and not on the recipient, where it should normally be.
The memorandum to the Finance Bill, 2020 suggested that this is income in the hands of the unit holders and not in the hands of the mutual fund.
The incidence of the tax should therefore, be on the recipient i.e. the unit holders.
Moreover, the present provisions levy tax at a flat rate on the distributed profits, irrespective of the marginal rate at which the recipient is otherwise taxed.
The provisions are hence, considered, iniquitous and regressive.
In view of above, The Finance Act, 2020 amended the provisions with regard to income from units of mutual fund and provided that such income shall be taxable in the hands of the unit holders at the applicable rates (slab-wise) and the mutual shall not be required to pay any tax.
The amendment, thus, abrogated the tax, on distribution of income by mutual funds (as provided under section 115-R) w.e.f. 1st April, 2020. The income so received, is now, to be taxed as income of the unit holder as per the respective individual slab rates applicable to them.
Let’s now have a look at the respective section wise amendments that are made effective by The Finance Act, 2020 w.e.f. 1st April, 2020:
|S. No.||Section Amended||Effect of the Amendment|
[Tax on distributed income to unit holders]
|This shall now be applicable to income distributed by a mutual fund on or before 31st March, 2020 only.|
[Exempts the income so received in the hands of unit holders]
|This shall not apply to any income in respect of units, received on or after 1st April, 2020.|
[TDS on the income distributed to the resident unit holders]
|Earlier, as the income received on units of mutual fund was tax exempt in the hands of unit holders, no TDS was deducted on such income.
However, The Finance Act, 2020 has now made such income taxable in the hands of unit holders and thus, TDS provisions have been made effective.
TDS @10% shall now be deducted by the mutual fund, on any such income distributed, of any amount, in excess of Rs. 5,000 to its resident unit holders. No TDS shall be deducted up to threshold provided of Rs. 5,000.
TDS shall be deducted at the time of credit of such income to the account of the payee or at the time of payment thereof, whichever is earlier.
Moreover, it has been further clarified that, such TDS shall not be deducted on the income which is of the nature of capital gains.
|Any expense incurred on earning exempt income is not deductible. Thus earlier, the interest paid to banker on loans taken for investment in units of mutual fund which were securities reaping tax-exempt income was not deductible. However, as such income is now no longer tax exempt in the hands of unit holders, The Finance Act, 2020 has now allowed deduction of such interest expense up to 20% of such income which is included in the total income of the unit holder in a financial year without any deduction under this section.|
Let’s now understand the post-budget status in the hands of an individual through an illustration.
Facts: Mr. A invests Rs. 2,50,000 in an Equity Oriented Mutual Fund and gets 2500 units at an NAV of Rs. 100 per unit. The fund distributes income in the form of dividend to its unit holders of Rs. 1,00,00,000. Mr. A receives Rs. 25,000 by way of income (dividend) on such units.
|Tax Implications in the hands of the|
|Mutual Fund||Unit Holder i.e. Mr. A|
1. As per the amendments made by the Finance Act, 2020 in Section 115-R, the income so distributed by the mutual fund shall not be subject to any tax payment by the mutual fund.
2. However, the mutual fund shall now be liable to deduct TDS @10% (as per Section 194K) on the income distributed to Mr. A (as it is in excess of Rs. 5,000). Rs. 2,500 shall thus, be deducted.
|The amount of Rs. 25,000 shall be included** in Mr. A’s total income and shall be chargeable to tax (as per slab rate applicable) as income under the head other sources.
1. Exemption under Section 10(35) has been removed by The Finance Act, 2020.
2. TDS deducted can be adjusted by Mr. A while filing income tax return /payment of tax against his total income.
The unit holders are thus made responsible for paying taxes as per their respective applicable slab rates and the mutual fund has been made free from the statutory requirement of paying taxes on distribution of income on such units. However, they have now been obligated with the responsibility of deducting TDS on such income distribution as per the necessary applicable provisions (i.e. Section 194K for resident assessee and Section 195 for non-resident assessee).
The above change has been made by The Finance Act, 2020 on the premise that the earlier system was regressive and iniquitous.
The incidence of tax, under the direct taxes, shall always be on the recipient of such income and not on the payer.
Thus, the amendment made is valid, keeping in view, the fundamental aspect of direct taxes.
It is pertinent to note that the tax is levied on the distributed income i.e. the amount of income distributed by the mutual fund.
The amendments made by the Finance Act, 2020 are therefore, applicable to income on the units of mutual fund that are distributed by way of interest and/or dividend. They are not
applicable to income on units in the nature of capital gains (i.e. on their sale, redemption or repurchase). This has been clarified by the act so notified.
In order to let our reader know in a better way, let’s have a quick look at how the capital gains (CG) are taxed on units of mutual fund:
|Units of Equity Oriented Mutual Fund||Units of other Funds|
|Long Term CG||Short Term CG||Long Term CG||Short Term CG|
|Taxable @10% under section 112A where:||Taxable @15% under section 111A where:||Taxable at the rates specified under section 112 @20%
(indexation benefit is available)
|Taxable at normal rates|
|– such units are sold through stock exchange and Security Transaction Tax (STT) is paid on such sale transaction.
– such units are sold to the mutual fund and STT has been paid on such sale.
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