Ensuring that your mutual fund portfolio has the utmost tax efficiency is essential. Fund taxation depends on the nature of the fund and holding period. But decide your investments on merit, then look for tax efficiency, if available.
Tax efficiency is something much sought after by investors, and rightly so. However, to be noted, tax efficiency should not be a fundamental parameter for your investment decisions. Decide your investments on merit, then look for tax efficiency, if available.
Equity mutual funds
Equity oriented mutual funds are more tax efficient; dividends are always tax free and in the growth option, it becomes tax free after one year of holding by virtue of it becoming eligible for long term capital gains (LTCG) taxation.
The only tax incidence in equity mutual funds is short term capital gains tax (STCG), which is up to one year of holding, at 15% plus surcharge and cess as applicable. We will discuss the STCG aspect of equity funds in a while. Clearly, efficiency is generated by either investing in the dividend option of an equity fund or in the growth option, which is taxable as capital gains, with a horizon of more than one year.
Debt mutual funds
Debt funds carry a higher tax burden. The eligibility period for LTCG taxation is three years, though as a category, debt funds are more stable than equity and the tax incentive for long-term investment orientation is required more for equities. Dividends from debt funds are subject to dividend distribution tax (DDT), which is 28.84% for individual investors and 34.6% for corporate investors.
The DDT rate is same for all investors, irrespective of tax bracket. Efficiency is generated by investing in the growth option of debt funds, rather than dividend option, with a horizon of more than three years. For investors in a lower tax bracket, growth option is better for any holding period as the taxation rate is lower.
Indexation in debt funds
The way LTCG works for debt funds is as follows: there is an ‘indexation’ allowed to compensate for inflation in the holding period, as per numbers announced by the government. The capital gains component after allowing for indexation is taxed at 20%, plus surcharge and cess as applicable.
There are cost inflation index (CII) numbers announced by Central Board of Direct Taxes for every financial year, having seen the CPI inflation for previous year. Let us see an illustration: the CII number for FY 2013-14 was 939 and that for FY 2016-17 was 1125.
Let’s assume you invested in a debt fund sometime in FY14 and redeemed sometime in FY17—just to recall—three years of holding period is required. The initial NAV of the fund was `10 and the final NAV was `12.25. The indexed cost of purchase will be 1125/939 X Rs 10 = Rs11.98. Hence the taxable component is only Rs 12.25— Rs 11.98 = Rs 0.27. The tax rate for LTCG is 20%; with a cess of 3% it comes to 20.6%. Tax works out to 20.6% of Rs 0.27 = Rs 0.055. Your net of tax return is `12.25 – `0.055 = `12.195, i.e., the tax incidence is low, post indexation.
STCG in debt funds
The difficult part is STCG in debt funds. This can be handled through set-offs, if it is available in your case. Short term capital loss (STCL) can be set off against STCG as well as LTCG, i.e., STCG can be set off against STCL. Having said that, in the current market conditions, losses are difficult to come by as asset prices across categories are rising.
Investors may get in touch with his/her tax consultant as there may still be scope for set-offs, if you have STCL from some other investment and it can be planned accordingly. The same applies for STCG from equity funds.
For companies subject to MAT taxation, everything is subject to the MAT rate of taxation, which is 18.5% plus surcharge (as applicable) and cess. Hence, the dividend option of debt funds is not advisable as DDT rates are higher as discussed earlier. The STCG rate is lower than it is for regular taxation companies and lower than the DDT rate.
For capital gains, there is no tax-efficiency-oriented attraction to hold it for three years as indexation benefit is not available. Everything being taxable at the flat rate, growth option is preferred and holding period can be anything from tax perspective.