Mutual Funds have emerged as preferred medium of investment by small and medium sized investors, given the convenience of transaction, liquidity and regulatory comfort. This is evidenced from the growing pool of the asset size being managed by the Indian Mutual Fund industry. As per the data provided by the industry body, Association of Mutual Funds in India (AMFI), the total Assets Under Management (AUM) of the industry stands at Rs. 61.33 Lac Crores, at the end of June, 2024 and has grown over six times in a span of a decade, under the present government.
Therefore, it’s important for every tax practitioner, CA, financial planner and investment advisors to have updated knowledge of the relevant income tax provisions, pertaining to the Mutual Fund investments, as taxes impact the investment returns and almost every Income tax return being filed now a days, has some Mutual Funds transactions to be given effect to.
The latest budgetary provisions, proposed through the Finance (No. 2) Bill, 2024, certainly has a bearing on all the categories of the mutual fund schemes.
In this article, I have tried to decipher the latest income tax provisions, on every single category of the mutual fund scheme. I would like to give a disclaimer that, this article is solely for the educational purposes and the readers and investors are requested to contact their tax consultants before taking any investment related decision. The author shall not be responsible for any loss caused, directly or indirectly, to any person, relying on the opinion of the author, as expressed through this article.
Categorisation of Mutual Funds By SEBI:
1. Equity – Includes Flexicap (No capwise restriction), Multicap(25:25:25 in each cap), Largecap (Min 80% in largecap), Midcap(Min 65% in midcap), Small Cap (Min 65% in small cap), Large and Midcap (Min 35% each in mid and large cap), Focused (Max 30 stocks no cap restriction), Value/Contra (65% in value), quant based (Stocks chosen by quant formulas), ELSS (min 80% in equities, no cap restriction), Dividend Yield Fund (Min 65% in high dividend paying stocks).
2. Debt – Includes 16 categories of debt funds, classified on different criteria like Macaulay duration, issuer, ratings etc. These funds are named as Overnight funds, Liquid Funds, Money Market Funds, Ultra Short Term Funds, Low Duration Funds, Short Term Funds, Medium Term Funds, Medium to Long term funds, Long duration funds, Dynamic Bond Funds, Floater funds, Credit risk funds, Corporate bond funds, Government Bond (GILT) funds, Constant Maturity Gilt Funds, Banking and Public sector (PSU) Debt Funds.
3. Hybrid Funds – These are the funds having minimum two asset classes and can have even more in different combinations. Officially there are six sub-categories of Hybrid Fund. Conservative Hybrid Funds (Equity max 25%, rest debt), Balanced Hybrid Funds (Equity range 40%-60%, no arbitrage allowed), Aggressive Hybrid Funds (Equity Range 65% to 80%), Dynamic Asset Allocation or Balanced Advantage Funds (Equity Range open and is generally model based, arbitrage allowed), Multi Asset Allocation Funds ( Min. three asset classes like equity, debt and gold), Arbitrage Funds ( combination of equity arbitrage and debt/money market), Equity Savings Fund (Combination of equity, debt, arbitrage)
4. Solution Oriented Funds – These funds have higher lock in and provide solutions for retirement needs and financial planning for the minor children. Therefore, at present It includes Funds like Retirement Funds and Children Funds.
5. Other Schemes – These schemes include Fund of Funds (FOF) both domestic and international, Index Funds, ETFs and other such funds, which do not fall in any of the first four categories. Minimum 95% of these funds should be invested in the mother fund/ index.
INCOME TAX PROVISIONS:
Income Tax Act categorises Mutual Funds in a way, which is different from the SEBI and Industry classification. For Example, An International Equity Fund is an equity fund from SEBI and Industry classification perspective, but, non- equity from Income Tax Angle.
Therefore, regardless of the nomenclature used by the industry participants and the SEBI’s official classification norms, a fund has to be correctly classified, for the Income Tax purposes, keeping in mind the relevant taxation provisions only.
It is interesting to mention that two funds, falling in the same SEBI specified category, may have different Income Tax categorization. This is especially true w.r.t. the hybrid funds. Little bit of equity portion tweaking, may change the tax category from equity to non –equity or even specified mutual fund. Therefore, only the correct classification shall lead to correct tax liability on redemption.
The sections which have certain amendments proposed in the Finance Bill (No 2),2024 and which impact the Mutual Fund income’s taxation, are –
> Change in the Definition of the Short Term Capital Asset [S.2(42A)] w.e.f. 23-07-2024, effectively reducing long term holding period for non-equity and non-specified mutual funds, from 36 month to 24 months, if redeemed on or after 23-07-2024;
> Changes in Section 48 laying down the new computation method and removing indexation w.e.f. 23-07-2024;
> Section 50AA redefining Specified Mutual Funds w.e.f. 01-04-2026 (AY 2026-27);
> Section 111A raising STCG rate from 15% to 20% w.e.f. 23-07-2024
> Section 112, decreasing the rate of tax on non-equity and non-specified Mutual Funds LTCG from 20% to 12.5% w.e.f. 23-07-2024 and ;
> Section 112A increasing tax on equity LTCG from 10% to 12.5% w.e.f. 23-07-2024 and also raising the exemption limit of equity LTCG from one Lac to 1.25 Lac, in aggregate.
So, lets now move to understand the taxation provisions category wise and date wise, as per the Finance Bill (No.2), 2024.
A. Categorisation & Taxation of Mutual Fund Investments done till 31st March 2023 :
Only two categories were there:
a. Equity (Min 65 % in Listed Domestic Equities, Definition Section 112A). Effectively this category included all the equity funds, hybrid and multi asset funds having equity exposure above 65%); and
b. Non- Equity (Less than 65% in Listed Domestic Equities). It included all funds, other than equity, as explained above.
Taxability proposed by The Finance Bill (No2),2024 is as follows:
i) If sold/redeemed between 01-04-2024 to 22-07-2024
Equity- STCG (Up to 12 Months Holding) @15% (Section 111A) Equity- LTCG (More than 12 Months Holding) @10% (Section 112A)
Non Equity- STCG (Up to 36 Months) – As per investor’s slab (No special rate) Non Equity- LTCG (More Than 36 Months) – 20% with Index (Section 112)
ii) If sold/redeemed between 23-07-2024 to 31-03-2025
Equity- STCG (Up to 12 Months Holding) @ 20% (Section 111A) Equity-LTCG (More than 12 Months Holding) @12.5%, (Section 112A)
Non Equity- STCG (Up to 24 Months) – As per investor’s slab (No special rate) Non Equity- LTCG (More Than 24 Months) – 12.5% without Index (Section 112)
Equity Capital Gains exemption up to Rs.1.25 Lacs for FY2024-25 Shall be available, in aggregate.
B. Categorisation For Investments done Between 1ST April 2023 to 31st March 2025:
W.e.f. 01-04-2024 (i.e. AY 2024-25) a new section 50AA was introduced by the Finance Act,2023. This section created a special category of Mutual Funds, named “Specified Mutual Fund Scheme”.
Here it’s very important to note that “Specified Mutual Fund Scheme”, herein after called “SMF” in this article, now has two definitions. One definition applicable till 31st March 2026 (till AY 2025-26) and new definition which will be effective from 1st April,2026 (AY 2026-27). The new definition is inserted by the Finance Bill (No.2), 2024.
“Specified Mutual Fund Scheme (SMF)” existing definition as applicable on investments made till 31-03-2025, includes only those mutual fund schemes, which have Indian Equity Exposure less than 35%; and
“Specified Mutual Fund Scheme (SMF)” new definition as applicable w.e.f. 01-04- 2026 (i.e. investments on or after 01-04-2025) includes only the funds, which have invested more than 65% in debt and money market securities or any FOF investing in mother fund/s, which in turn invests more than 65% in debt and money market instruments.
Its again important to note that, both in the existing Section 50AA and also in the amended one, SMF is specifically categorized as Short Term Capital Asset (STCA) only, regardless of the holding period. This specific provision overrides S.2(42A), which defines STCA.
For example, if you hold an SMF for even five years, it will be STCA only.
Therefore, post 31st March,2023, effectively three categories of Mutual Funds came into being, from the taxation perspective. These are-
a. Equity Mutual Funds (Min 65 % in Listed Domestic Equities)
b. Specified Mutual Funds (SMF)
c. Non-Equity and Non-Specified Mutual Funds (i.e. other mutual funds or OMF)
Now taxation of these three types of funds, will be decided by the date of investment and also date of sale/ redemption, as explained below:
i) If sold/redeemed between 01-04-2024 to 22-07-2024
Equity- STCG(Upto 12 Months Holding) @15% (Section 111A) Equity- LTCG (More than 12 Months Holding) @10% (Section 112A)
SMF (Any holding period STCA) taxable at slab rate. No special rate.
OMF STCG (Upto 36 Months) – As per the slab of investor (No special rate) OMF LTCG (More Than 36 Months) – 20% with Index (Section 112)
ii) If sold/redeemed between 23-07-2024 to 31-03-2025
Equity- STCG(Upto 12 Months Holding) @20% (Section 111A)
Equity- LTCG (More than 12 Months Holding) @12.5% (Section 112A)
SMF (Any holding period STCA) taxable at slab rate. No special rate.
OMF STCG (Upto 24 Months) – As per the slab of investor (No special rate) OMF LTCG (More Than 24 Months) – 12.5% without Index (Section 112)
Equity Capital Gains exemption up to Rs.1.25 Lacs for FY2024-25 shall be available, in aggregate.
Tax Planning has become very difficult due to sudden and mid -year change in the tax structure. Though hybrid funds have excellent investment solutions to meet needs of wider set of investors, yet the changes in the definition of SMF must always be kept in mind while choosing any Hybrid Fund to invest. Any misunderstanding or misinterpretation, may result into slab rate of taxation, which is more pinching for the investors falling in the higher tax brackets i.e. 15% and above.
Post 31st March 2025, investment in most of the Fund of Funds, Asset Allocator Funds, International funds, Funds neither falling in equity category nor in SMF, shall enjoy far superior post tax return, given the fact that, long term capital gain tax rate on these funds, is now equal to that of equity (12.5%). However, they must be held for minimum 24 months, before being redeemed or switched.
TAXATION OF SIP /STP/SWP :
Tax treatment of gains arising on account of redemption from the scheme on closure or completion of SIP or even Switch to another scheme is considered as transfer, and holding period is to be calculated as difference in number of days between purchase and redemption/switch of each single unit or each single SIP.
Tax shall be levied based on nature of the scheme (Equity, SMF, OMF) and the holding period of each unit/installment.
Systematic Withdrawal Plan (SWP) is far superior, on post tax basis, for those investors, who need regular cash flows, as compared to the dividend plan, provided the investor’s tax slab is more than 10%. Retirees are the biggest beneficiary of SWP.
TAXATION OF DIVIDENDS:
Legally, terminology used is now “Income Distribution Cum Withdrawal plan” (IDCW). This option used to be good for those investors, who needed some kind of regular cash inflow and was tax exempt earlier, in the hands of investors, though Dividend Distribution Tax (DDT) was collected at the fund level. However, Finance Act,2020 removed DDT and made dividend taxable in the hands of investors. Post this amendment, Dividend option is good only for low slab investors now.
Summary :
The world of Mutual Funds is very vast and deep, given the fact that despite SEBI categorization norms coming into effect six years ago, a lot of new NFOs hit the market every month and the total no. of schemes, available for investments, now run in thousands, further complicated by the similar sounding names, making it difficult for investors, to invest in any scheme with full conviction. This is on two account, increased no. of SEBI registered Asset Management Companies (Appx 50 Now) and the competition amongst them to raise maximum funds, as it is the fees income, based on their Asset Under Management (AUM), which decides their profitability and growth. I have tried to summaries the taxation provisions, from the point of view of the investors. The readers are requested to kindly let me know, something that I may have missed. Kindly provide your feedback and suggestions.
Author :- CA Uma Shankar Tiwari, FCA, MA(Economics), LLB, DISA(ICAI), Senior Investment Industry Trainer, email: [email protected]
