Tax efficiency in mutual funds is a function of horizon.
When we look for tax efficiency in mutual fund investments, we prefer equity over debt. Many of us believe that equity schemes are more tax efficient.
However, tax efficiency is a function of time horizon. Let me explain this to you: Assume an investment horizon of up to 1 year. In equity funds, investors have to pay short term capital gains tax of 15% tax on realized gains along with applicable surcharge and cess if they redeem units within a year.
In debt funds, investors have to pay short term capital gains if they redeem their investing within 36 months. The tax rate is marginal rate of taxation i.e. the gains are added to investors’s annual income and taxed at the applicable slab. Hence, debt funds are not tax efficient for investors especially falling under 30% slab.
For the next holding period i.e. 1-3 years, still equity funds are more tax efficient. Investors can avail benefits of tax exemption on up to Rs.1 lakh per financial year. After one lakh, investors have to pay 10% long term capital gains tax along with applicable surcharge and cess. In this holding period, debt funds are subject to pay short term capital gains tax at marginal rate of taxation.
Now, coming to the last part i.e. beyond three years, the common perception is that equity is more tax efficient. For equity, it is 10% plus applicable surcharge and cess on gains exceeding Rs.1 lakh. In debt funds, it is 20% plus applicable surcharge and cess, after factoring in benefit of indexation. Hence, the effective rate of taxation depends on the indexation benefit given by the government (Central Board of Direct Taxes). In the past, debt funds investors have paid less than 10% on gains made from debt funds due to benefits of indexation.
Since the start of the current series of cost inflation index (CII) i.e. 2001-02 = 100, we have taken two hypothetical rates of return in debt investments (7% and 8%) for computing the effective tax rate. The method of calculation is, for every year, assuming you invested Rs 100 one year ago, at the given level of CII, what is your effective tax rate at 20% (prior to surcharge and cess) as a percentage of your gain. At 7% assumed rate, the effective tax rate is as low as 2.93%. At 8% assumed rate of return on debt investments, the effective tax rate on an average is 5%.
The effective tax rate in debt MFs for holding period of over three years can very well be less than equity funds. Remember, FoF has a debt like tax structure even if the underlying funds are equity. This makes it attractive for investors having time horizon of over 3 years.