There seems to be a lot of confusion regarding the new taxation rule regarding debt funds. Here we break it down in a simple way with an explanation of what that entails. Just one clarification before we proceed; All the mentioned tax rates exclude cess and surcharge.
What is Capital Gains tax?
The Income Tax department categorizes all sources of income under 5 heads:
- Salary
- House Property
- Profits and Gains from business/profession
- Capital Gains
- Other Sources
What is capital gain? When you make a profit by selling an asset, it is known as a capital gain (difference between the purchase price and the sale price).
What is an asset? Gold, jewellery, fixed-income instruments, stocks, mutual funds, land, buildings, houses, apartments, paintings, sculptures, and cars are examples of assets.
This is further divided into short-term capital gains (STCG) and long-term capital gains (LTCG).
What is STCG & LTCG?
Depends on the period of holding.
- Generally, if you sell your asset before the completion of 36 months of holding, the gain is treated as STCG. If you sell your asset after the completion of 36 months of holding, the gain is treated as LTCG.
- In some instances, the period of holding to be considered is 12 months instead of 36 months. So if you sell after 12 months, it is considered as LTCG. Shares, equity mutual funds, listed securities like debentures and Government Securities, units of UTI and zero-coupon bonds, fall under this rule.
- In some instances, the period of holding to be considered as 24 months instead of 36 months. If you sell after 24 months, it is considered as LTCG. Unlisted shares of a company and immovable property (land or building) qualify.
For example, let us say Kapil and Anita purchased gold in April 2019. Kapil sold it in December 2020. Anita sold it in December 2022. In both cases, gold was a capital asset for each. But for Kapil, it will be treated as a short-term capital asset (he held it for a period of less than 36 months). For Anita, it will be treated as a long-term capital asset (she held it for a period of more than 36 months).
Read it in detail on the Income Tax website
What is the tax rate for mutual funds?
The taxability of capital gains depends on the nature of gain, i.e., whether short-term or long-term.
STCG tax on stocks and equity mutual funds is 15%.
There was no LTCG tax on equity until the Union Budget 2018 introduced a flat 10% tax on stocks and equity mutual funds. This is a flat tax with no indexation benefit. There is one basic annual exemption limit – Rs 1 lakh. The tax is now 10% on gains in excess of Rs 1 lakh per annum.
Non-equity investments are taxed as per the income tax slab rate of the investor. Which means that if your tax rate is 30%, STCG tax is 30%.
LTCG tax for non-equity investments is 20% with indexation for investments made till March 31, 2023. From April 1, 2023 (FY23-24 onwards), capital gains from debt mutual funds will get added to their income and the relevant tax slab rate will be applicable, irrespective of their holding period.
What are the equity and debt components of mutual funds?
- Equity: Minimum 65% of their portfolio in equity shares of domestic companies.
- Debt: Minimum 95% of their portfolio in debt instruments.
- Aggressive Hybrid: 65%-80% in equities and 35%-20% in debt.
- Balanced Hybrid: 40%-60% in equities and 60%-40% in debt.
- Dynamic Asset Allocation: Determine the equity and debt allocation depending on their strategy and how they view valuations and interest rates. They are also known as Balanced Advantage Funds (BAFs).
- Arbitrage: Minimum 65% in equity instruments via hedged or unedged allocations. The fund manager will attempt to leverage the price differential in the cash and derivatives market to generate returns. These funds are hybrid in nature as they also invest in debt instruments.
(When it comes to taxation, Gold ETFs, Gold FoFs, FoFs and global funds fall into the debt fund category for taxation purposes.)
Please remember!
- When it comes to debt funds, the change is only applicable from investments made from April 1, 2023. Investments made till March 31, 2023, will continue to attract LTCG taxation once they complete 3 years. So for fresh investments, do consider a separate folio.
- You can also look at bank fixed deposits since the interest rates are attractive and the taxation is similar.
- When constructing a portfolio, you need to look at your risk appetite, period for which you want the money invested, diversification, asset allocation, and tax implication. There should not be one single factor that is the sole driver of your decision.
- When it comes to a specific product, you need to consider returns, liquidity, transparency and how it fits in with your overall portfolio.
Abbreviations:
- ETF: Exchange Traded Fund
- FoF: Fund of Funds
- STCG: Short Term Capital Gain
- LTCG: Long Term Capital Gain
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