Learn about taxation of mutual funds in India & USA, including capital gains tax, dividend tax, differences in taxation systems, GST applicability, & international taxation.
Article explains Meaning of Mutual Funds and Their Types, Mutual Funds Taxation In India, Mutual Funds Taxation In United States, Differences In Taxation System of Mutual Funds In INDIA And USA, GST Applicability In Mutual Funds and Applicability Of International Taxation In Mutual Funds.
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Meaning of Mutual Funds and Their Types
Mutual funds are investment vehicles that pool money from multiple investors to invest in a portfolio of assets, such as stocks, bonds, or other securities. The portfolio is managed by professional fund managers, who buy and sell securities on behalf of the investors.
There are several types of mutual funds available to investors, each with its own investment objective, risk profile, and investment strategy. Here are some of the most common types of mutual funds:
Equity Funds: Equity funds invest primarily in stocks, and are designed for investors seeking long-term capital appreciation. They may be focused on a specific sector or industry, such as technology or healthcare, or may invest more broadly across the entire stock market.
Debt Funds: Debt funds invest primarily in fixed-income securities, such as bonds or money market instruments, and are designed for investors seeking regular income with a lower level of risk than equity funds. They may invest in government bonds, corporate bonds, or a combination of both.
Balanced Funds: Balanced funds invest in a mix of stocks and bonds, with the goal of achieving a balance between capital appreciation and income generation. They may be actively managed or follow a predetermined asset allocation.
Index Funds: Index funds are designed to track the performance of a specific market index, such as the S&P 500 or the Dow Jones Industrial Average. They typically have lower fees than actively managed funds, since they require less management.
Specialty Funds: Specialty funds invest in specific sectors or industries, such as technology, healthcare, or real estate. They may be actively managed or passively managed.
Money Market Funds: Money market funds invest in short-term, low-risk securities, such as Treasury bills or certificates of deposit. They are designed for investors seeking a high degree of safety and liquidity, and typically have low yields.
Target-Date Funds: Target-date funds, also known as lifecycle funds, are designed to automatically adjust their asset allocation over time based on the investor’s target retirement date. They typically start with a higher allocation to stocks when the investor is younger and gradually shift to a higher allocation to bonds as the retirement date approaches.
Sector Funds: Sector funds invest in specific sectors of the economy, such as technology, energy, or healthcare. They offer investors the opportunity to focus on a particular area of the market, but also come with higher risk since they are not diversified across multiple sectors.
International Funds: International funds invest in companies outside of the investor’s home country, providing exposure to foreign markets and currencies. They may focus on a specific region, such as Europe or Asia, or invest more broadly across multiple countries.
Alternative Funds: Alternative funds use non-traditional investment strategies, such as derivatives, commodities, or real estate, to generate returns. They are designed for investors seeking higher returns and diversification beyond traditional stocks and bonds, but also come with higher risk and fees.
Socially Responsible Funds: Socially responsible funds, also known as ESG (environmental, social, and governance) funds, invest in companies that meet certain ethical or social criteria, such as reducing carbon emissions or promoting diversity and inclusion. They allow investors to align their investments with their values.
Index-Enhanced Funds: Index-enhanced funds, also known as enhanced index funds, use a combination of passive and active management strategies to outperform a market index. They may use quantitative techniques, such as stock screening or factor-based investing, to achieve higher returns.
Fund of Funds: Fund of funds invest in other mutual funds, providing investors with exposure to multiple funds and asset classes with a single investment. They may be actively managed or passively managed.
These are some of the most common types of mutual funds, although there are many other variations available to investors, such as target-date funds or socially responsible funds. It’s important to choose a mutual fund that aligns with your investment goals and risk tolerance.
Mutual Funds Taxation In India
In India, mutual funds are subject to different types of taxes depending on the type of fund and the holding period of the investment. Here is a summary of the various taxes on mutual funds in India:
- Short-Term Capital Gains Tax: If an investor holds mutual fund units for less than one year (i.e. 365 days), any gains from the sale of those units are considered short-term capital gains and are taxed at a rate of 15% plus applicable surcharge and cess.
- Long-Term Capital Gains Tax: If an investor holds mutual fund units for more than one year, any gains from the sale of those units are considered long-term capital gains. Long-term capital gains up to Rs. 1 lakh are exempt from tax, while gains above Rs. 1 lakh are taxed at a rate of 10% plus applicable surcharge and cess.
- Dividend Distribution Tax: When a mutual fund distributes dividends to its investors, it is required to pay a dividend distribution tax (DDT). The current rate of DDT on equity funds is 11.648% (including surcharge and cess) and on debt funds is 29.12% (including surcharge and cess). From April 1, 2020, DDT has been abolished, and instead, dividends from mutual funds are now taxable in the hands of investors at their applicable tax rate.
- Securities Transaction Tax: When an investor buys or sells mutual fund units, they are subject to a securities transaction tax (STT). The current rate of STT on equity-oriented mutual funds is 0.001%, while on debt-oriented mutual funds it is 0.0005%.
- Capital Gains Tax on Equity-Linked Saving Schemes (ELSS): ELSS is a type of mutual fund that offers tax benefits under Section 80C of the Income Tax Act. Investments in ELSS are eligible for deduction up to Rs. 1.5 lakh per year from taxable income. The gains from ELSS are subject to long-term capital gains tax of 10% on gains above Rs. 1 lakh.
Illustration:-
Here’s an example of how mutual fund taxation works in India:
Suppose an investor bought 1,000 units of an equity mutual fund on January 1, 2021, at a net asset value (NAV) of Rs. 50 per unit, investing a total of Rs. 50,000. The investor sold all the units on December 31, 2021, at an NAV of Rs. 60 per unit, receiving Rs. 60,000. The investor did not receive any dividend income from the mutual fund during the holding period.
Short-Term Capital Gains Tax:
Since the investor held the mutual fund units for less than one year, the gains from the sale of units are considered short-term capital gains. The taxable gain is calculated as follows:
- Sale value – Purchase value = Rs. 60,000 – Rs. 50,000 = Rs. 10,000
- Short-term capital gains tax at 15% = Rs. 10,000 x 15% = Rs. 1,500
Therefore, the investor will have to pay short-term capital gains tax of Rs. 1,500.
Long-Term Capital Gains Tax:
Suppose the investor had held the mutual fund units for more than one year and sold them on December 31, 2022, at an NAV of Rs. 70 per unit, receiving Rs. 70,000. Since the investor held the mutual fund units for more than one year, the gains from the sale of units are considered long-term capital gains. The taxable gain is calculated as follows:
- Sale value – Cost Inflation Index (CII) adjusted purchase value = Rs. 70,000 – (50,000 x 308/301) = Rs. 71,827
- (Long-term capital gains up to Rs. 1 lakh are exempt from tax)
- Taxable long-term capital gain = Rs. 71,827 – Rs. 1 lakh = Rs. 21,827
- Long-term capital gains tax at 10% = Rs. 21,827 x 10% = Rs. 2,183
Therefore, the investor will have to pay long-term capital gains tax of Rs. 2,183.
It’s important to note that the above illustration is just an example and the actual tax liability on mutual fund investments may vary depending on various factors such as the type of mutual fund, the holding period, the tax slab of the investor, and other applicable taxes and surcharges.
Mutual Funds Taxation In United States
Mutual funds in the United States are subject to specific tax rules. Here are some important things to know about the taxation of mutual funds in the USA:
- Capital Gains Taxes:
Capital gains are profits made when selling an asset at a higher price than the cost basis. Mutual funds buy and sell securities, and when they sell securities for more than they paid for them, they realize capital gains. Mutual funds are required to distribute at least 95% of their realized capital gains to investors annually. The capital gains can be short-term or long-term, depending on how long the mutual fund held the securities before selling them. Short-term capital gains are gains on securities held for one year or less, while long-term capital gains are gains on securities held for more than one year. Short-term capital gains are taxed at the investor’s ordinary income tax rate, which can be as high as 37% depending on the investor’s income level. Long-term capital gains are taxed at a lower rate, ranging from 0% to 20% depending on the investor’s income level.
- Dividend Taxes:
Mutual funds may also distribute dividends to their investors, which are taxable to the investor. Dividends can be qualified or non-qualified. Qualified dividends are taxed at the same rates as long-term capital gains. To be considered qualified, the dividend must be paid by a U.S. corporation or a qualified foreign corporation and the investor must hold the stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date. Non-qualified dividends are taxed at the investor’s ordinary income tax rate.
- Taxes on Reinvested Dividends:
Mutual fund investors can choose to have their dividends automatically reinvested in additional shares of the fund. While the investor does not receive the dividend in cash, they are still taxed on the dividend. The reinvested dividends increase the investor’s cost basis in the mutual fund, which can reduce future capital gains taxes.
- Net Investment Income Tax:
Some investors may be subject to an additional tax on their mutual fund investments if their income exceeds certain thresholds. The net investment income tax (NIIT) is 3.8% and is applied to the lesser of the investor’s net investment income or the amount by which their modified adjusted gross income exceeds the threshold amount. The threshold amounts are $200,000 for single filers and $250,000 for married filing jointly.
- Basis Reporting:
Mutual funds are required to report the cost basis of securities sold within the fund to both the IRS and the investor on Form 1099-B. This helps investors accurately calculate their capital gains taxes. Starting in 2019, brokers are required to track and report cost basis for mutual fund shares acquired after January 1, 2012.
Illustration:-
Let’s walk through an example of how taxes on mutual funds are calculated in the USA. Suppose you are a single filer with a taxable income of $80,000 in 2023 and you hold a mutual fund in a taxable account. The mutual fund earned $2,000 in dividends and realized a $3,000 long-term capital gain during the year. The mutual fund also had $1,000 in reinvested dividends. Let’s assume that the mutual fund has a cost basis of $20,000.
To calculate your taxes on the mutual fund, you will need to calculate the tax on the dividends and the tax on the capital gains separately.
Dividend Taxes:
The $2,000 in dividends received from the mutual fund will be taxed as follows:
- $2,000 in qualified dividends: Since the qualified dividend tax rate is the same as the long-term capital gains tax rate, the tax rate for these dividends will be 15%, since your income falls in the 22% tax bracket.
- Tax on qualified dividends: $2,000 x 15% = $300.
- $0 in non-qualified dividends: In this example, all of the dividends received from the mutual fund are qualified, so there are no non-qualified dividends to be taxed at your ordinary income tax rate.
Capital Gains Taxes:
The $3,000 in long-term capital gains realized by the mutual fund will be taxed at the following rate:
- $3,000 in long-term capital gains: Since your income falls in the 22% tax bracket, your long-term capital gains tax rate will be 15%.
- Tax on long-term capital gains: $3,000 x 15% = $450.
Reinvested Dividends:
Although you did not receive the $1,000 in reinvested dividends in cash, they are still subject to taxes. The reinvested dividends increase your cost basis in the mutual fund, which will reduce your future capital gains taxes.
Net Investment Income Tax:
Since your income is below the threshold of $200,000 for single filers, you are not subject to the net investment income tax.
Total Tax Owed on Mutual Fund:
The total tax owed on the mutual fund is the sum of the tax on dividends and the tax on capital gains:
$300 (tax on qualified dividends) + $450 (tax on long-term capital gains) = $750(total).
Differences In Taxation System of Mutual Funds In INDIA And USA
The taxation of mutual funds in India and the USA differs in several ways. Here are some of the key differences:
- Dividend Distribution Tax (DDT):
In India, mutual funds are subject to a dividend distribution tax (DDT) on the dividends paid to investors. The DDT is currently 28.84%, which is paid by the mutual fund before distributing the dividends to investors. In the USA, mutual funds are not subject to a dividend distribution tax at the federal level, although some states may impose state-level taxes on mutual fund dividends.
- Capital Gains Taxes:
The taxation of capital gains on mutual funds is similar in both India and the USA in that gains on mutual fund investments held for more than one year are considered long-term capital gains and taxed at a lower rate than gains on investments held for one year or less. However, the specific tax rates and rules differ between the two countries.
In India, long-term capital gains on equity mutual funds are currently taxed at a rate of 10% if the gains exceed INR 1 lakh ($1,361), while long-term capital gains on debt mutual funds are taxed at a rate of 20% with indexation benefits.
In the USA, the long-term capital gains tax rate varies depending on the investor’s income level, ranging from 0% to 20%. Short-term capital gains on mutual funds are taxed as ordinary income in both countries.
- Cost Basis Reporting:
In the USA, mutual funds are required to report the cost basis of securities sold within the fund to both the IRS and the investor on Form 1099-B. This helps investors accurately calculate their capital gains taxes. Starting in 2019, brokers are required to track and report cost basis for mutual fund shares acquired after January 1, 2012. In India, there is no requirement for mutual funds to report cost basis to investors.
- Tax on Reinvested Dividends: In the USA, investors are taxed on reinvested dividends even though they are not received as cash. The reinvested dividends increase the investor’s cost basis in the mutual fund, which can reduce future capital gains taxes. In India, reinvested dividends are not taxed separately, but they are included in the cost of acquisition for the purpose of calculating capital gains tax.
- Securities Transaction Tax (STT): In India, securities transaction tax (STT) is levied on the purchase and sale of securities, including mutual funds. The STT rate for equity mutual funds is currently 0.001% on the redemption of units, while the STT rate for debt mutual funds is 0.0001% on the redemption of units. There is no equivalent tax in the USA.
There are some additional differences between the taxation of mutual funds in India and the USA:
- Indexation Benefit:
In India, long-term capital gains on debt mutual funds are taxed at a rate of 20% with indexation benefits. Indexation allows the investor to adjust the cost of acquisition of the investment for inflation, which reduces the taxable gains. This means that the actual tax liability on long-term debt mutual funds is usually lower than the nominal tax rate of 20%. In the USA, there is no provision for indexation benefit on capital gains.
- Holding Period for Long-term Capital Gains:
In India, the holding period for an investment in equity mutual funds to be considered as long-term is one year or more. In contrast, in the USA, the holding period for an investment in mutual funds to be considered as long-term is more than one year.
- Taxation of Foreign Mutual Funds:
In India, foreign mutual funds are taxed at a higher rate compared to domestic mutual funds. The tax rate for long-term capital gains on equity-oriented foreign mutual funds is currently 20%, while the tax rate for short-term capital gains is 30%. In the USA, the tax treatment of foreign mutual funds depends on various factors such as the type of fund and the country of origin.
- Tax on Redemption of Mutual Fund Units:
In India, mutual fund units are subject to redemption tax when they are sold. The tax rate depends on the type of mutual fund and the holding period. In contrast, in the USA, there is no redemption tax on mutual fund units.
- Deduction of Expenses:
In the USA, investors in mutual funds may be able to deduct certain expenses related to their investments, such as advisory fees and custodian fees, from their taxable income. In India, there is no such provision for deduction of expenses related to mutual fund investments.
- Systematic Withdrawal Plan (SWP) and Systematic Investment Plan (SIP):
In India, mutual fund investors can opt for Systematic Withdrawal Plans (SWPs) and Systematic Investment Plans (SIPs) to receive regular payments or invest regularly in mutual funds, respectively. SWPs are subject to capital gains tax, while SIPs do not have any tax implications until the investor redeems their units. In the USA, regular investments in mutual funds are subject to the same tax rules as lump sum investments.
- Tax Deductions for Investments:
In India, investors can claim a tax deduction of up to INR 1.5 lakh ($2,041) per year under Section 80C of the Income Tax Act for investments in certain types of mutual funds, such as Equity-Linked Saving Schemes (ELSS). In the USA, there are no tax deductions specifically for mutual fund investments, but investors can deduct contributions to certain retirement accounts from their taxable income.
- Estate Taxes:
In the USA, there is a federal estate tax that applies to the transfer of wealth from a deceased person to their heirs or beneficiaries. Mutual fund investments are subject to this tax if the total value of the investor’s estate exceeds certain thresholds. In India, there is no estate tax.
GST Applicability In Mutual Funds
In India, mutual funds are subject to Goods and Services Tax (GST) under certain circumstances. Here are a few key points to keep in mind regarding GST applicability in mutual funds:
- Management fee charged by the mutual fund: Mutual funds charge a management fee for managing the fund’s investments. This fee is subject to GST at a rate of 18%.
- Distributor commission: Mutual funds may pay a commission to distributors for selling their products. This commission is also subject to GST at a rate of 18%.
- Securities Transaction Tax (STT): STT is a tax levied on the sale and purchase of securities, including mutual fund units. Since STT is a transaction tax and not a value-added tax, it is not subject to GST.
- Redemption charges: Some mutual funds charge redemption fees when investors redeem their units before a certain period. If the redemption charge is specified separately in the mutual fund’s offer document, it is not subject to GST. However, if the charge is not separately specified, it may be subject to GST at a rate of 18%.
- Other charges: Some mutual funds may charge additional fees, such as exit loads, account maintenance charges, etc. The GST applicability on these charges may vary depending on their nature and whether they are specified separately in the mutual fund’s offer document.
It’s important for investors to understand the GST implications on their mutual fund investments. The GST charged on mutual funds is usually deducted from the investor’s pay-out, so it’s important to factor in these charges when calculating the expected returns on the investment. It’s advisable to consult with a tax professional or financial advisor for guidance on the GST implications of mutual fund investments.
Applicability Of International Taxation In Mutual Funds
When investing in mutual funds that are domiciled outside of one’s home country, international taxation may come into play. Here are a few key points to keep in mind regarding international taxation of mutual funds:
- Taxation in the country of origin: The taxation of mutual funds depends on the tax laws of the country where the fund is domiciled. For example, if an Indian investor invests in a mutual fund that is domiciled in the United States, the investor will be subject to the tax laws of both countries.
- Taxation in the home country: In addition to taxation in the country of origin, the investor may also be subject to taxation in their home country. For instance, Indian residents who invest in foreign mutual funds are required to report their investments in their income tax returns and pay tax on any income earned from such investments.
- Double taxation avoidance agreements (DTAAs): Some countries have entered into DTAAs with other countries to avoid double taxation. These agreements ensure that an investor is not taxed twice on the same income. For example, India has entered into DTAAs with several countries, including the United States, to avoid double taxation of income.
- Withholding taxes: Many countries levy a withholding tax on dividends and capital gains earned by non-resident investors. These taxes are usually deducted at source before the investor receives their pay-out. The withholding tax rate may vary depending on the country of origin of the mutual fund and the tax laws of the investor’s home country.
- Foreign Account Tax Compliance Act (FATCA): The FATCA requires foreign financial institutions, including mutual funds, to report their U.S. account holders to the U.S. Internal Revenue Service (IRS). This has led many foreign mutual funds to restrict or prohibit U.S. investors from investing in their funds.
It’s important for investors to understand the taxation rules and regulations of the countries where they are investing in mutual funds. It’s advisable to seek guidance from a tax professional or a financial advisor who is well-versed in international taxation to help navigate the complexities of investing in foreign mutual funds.
Conclusion
In conclusion, mutual funds are a popular investment vehicle that allow investors to pool their money together to invest in a diversified portfolio of securities. Mutual funds offer several benefits, such as professional management, diversification, liquidity, and convenience. They also come in various types to suit the different investment goals and risk appetites of investors.
However, like any investment, mutual funds carry their own set of risks, including market risk, credit risk, and interest rate risk. It’s important for investors to carefully evaluate a mutual fund’s performance, fees, and risk before investing. Additionally, investors should be aware of the taxation rules and regulations that apply to mutual fund investments, both in their home country and in the country of origin of the fund, especially in case of investing in foreign mutual funds.
Overall, mutual funds can be a valuable addition to an investor’s portfolio, but it’s important to conduct thorough research and seek professional guidance before making any investment decisions.
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how do I get indexation benefits on the tax on qualified dividends, since the cost basis is not know?