How to calculate tax on mutual funds? (Cafe Mutual - 21st Feb 2013)

Melvin Joseph of Finvin Financial Planners explains the applicability and calculation of taxes on different fund categories.

When you allocate investments for long term financial goals, taxation will make lot of difference on your client’s corpus accumulation. If they are getting it tax free like PPF, it is always good.

Let us see how to calculate tax on mutual funds. First of all let us study what are the heads under which we get income from mutual funds. If your client’s investment is in growth option of the mutual fund, the gain will be reflected by way of increase in net asset value (NAV). This gain is called the capital gain. But, if they have opted for dividend option, the gain will be by way of periodic dividend also.

Let us see how to calculate tax on mutual funds under these two heads.

How to calculate capital gain tax on mutual funds?

1.   Equity mutual funds

For taxation purpose, funds with 65% or more allocation in equity are classified as equity funds. So balanced funds like HDFC Prudence, HDFC Balanced etc. also will come under this category.

Suppose you have invested 1 lakh in Feb. 2005 in HDFC Prudence fund. The value of this investment is around 4 lakhs today. How much is the capital gain? It is 4 lakhs   – 1 lakhs = 3 lakhs. You want to sell this fund today for buying a car. How to calculate tax payable in this scenario?

Here is the good news. You need not pay any tax on this gain of 3 lakhs. This is because the long term capital gain from equity mutual fund is tax free.

What is long term capital gain?

It is the gain you are getting, when you are selling the mutual fund after 365 days of its purchase. As per the current tax rules, long term capital gains from equity mutual funds are tax free.

What is short term capital gain?

It is the gain you are getting, when you are selling the mutual fund within 365 days of its purchase. As per the current tax rules, you have to pay 15% tax on the short term capital gains from equity mutual funds. With 3% cess, it will be 15.45%.

2.   Debt mutual funds

In addition to normal debt funds, funds with less than 65% in equity, international funds, gold funds, fund of funds etc. are also considered as debt funds for taxation purpose.

In debt funds, the short term capital gains are fully taxable. You have to pay tax as per your tax slab. Suppose you are getting Rs 30,000 as short term gain by selling a debt fund within 1 year and if your salary income is 4 lakhs, your taxable income will be 4, 30,000.

For long term capital gains in debt funds, you have to pay tax as follows

1. 20% with indexation benefits or
2. 10% without indexation benefits.

What is indexation?

Indexation helps you to offset your gain with the effect of inflation. Government will notify the cost of inflation index every year. Please note the cost of inflation index for the recent 3 financial years.

2010-11: 711,        2011-12: 785,        2012-13: 852

Let us see how to calculate capital gain for debt funds?

Suppose you have invested 1 lakh in a debt fund in January 2011 and are selling in Feb. 2013 for 1, 20,000.

Your original investment = 100000

Indexed cost:  1, 00,000 x 852/711 = 1, 19,831.

Capital gain after indexation = 1, 20,000 – 1, 19, 831 = 169/- (sale price- indexed cost)

So, in this case, you have to pay 20% tax on the gain of Rs 169 only and not on the gain of 20,000!  Your tax liability is only 34/-. This is the benefit of indexation.

If you don’t want to apply indexation, you have to pay 10% tax on the gain of 20,000. Then the tax liability will be Rs 2000.

How to calculate tax on mutual funds dividend income?

1.   Equity mutual funds

There is no tax on mutual funds dividend you receive from equity mutual funds. It is tax free in your hands.

2.   Debt mutual funds

You need not pay any tax on mutual funds dividend you receive from debt mutual fund. But the mutual fund company is liable to pay dividend distribution tax to the government before paying the dividend to you.

Dividend distribution tax in debt mutual funds (DDT)

For liquid funds and money market funds, the DDT is 25%. There is another 5% surcharge on it along with 3% cess. So, the effective rate of tax will be 27.0375 %( 25% tax+ 5% surcharge+3% cess).

In other debt funds, the DDT rate is lower. It is 12.5 %. There is another 5% surcharge on it along with the 3% cess. So, the effective rate of tax will be 13.5188%.

Will they deduct tax on mutual funds income?

No, the fund house will not deduct the tax from your gain. You have to calculate and pay tax on mutual fund income. But for NRIs, tax on mutual funds will be deducted as per the applicable rates before paying.

So how are mutual fund investments more tax-efficient?

Here, you pay tax only at the time of redemption. But in bank deposits, you have to pay tax every year on accrual basis. With indexation benefits, debt funds are more attractive than fixed deposits. Equity funds after one year are totally tax free.

Hope that this article was useful in understanding the tax on mutual funds.

The article was first published on http://www.finvin.in

The views expressed in this article are solely of the author and do not necessarily reflect the views of Cafemutual.

Making indexation work to your clients advantage (Cafe Mutual 5th Feb 2013)

Dilshad Billimoria of Dilzer Consultants explains the importance and application of indexation in various asset classes.

Before getting into an explanation of indexation, let us look at the definition of a few related things.

Capital Asset: This is an asset that is not easily sold in the regular course of business operations for cash. Examples include land, buildings, and machinery that cannot be quickly converted to cash.

Capital Asset is any asset held by the Income Tax Assessee but does not include:

·         Jewellery, art, or drawings.

·         Any stock in trade held by a business in the course of its day to day operations.

·        Agricultural land which is outside the radius of 8 km of municipal limits and has a population of less than 10000. 

Capital Gain: Any appreciation in the value of an asset from its purchase price is gain. The gain is not realized until the asset is sold.

For e.g., if you have invested Rs 1 lakh in an equity mutual fund and it has appreciated by 10% after 1 year, the gain is said to be unrealized, until the asset is actually sold. Once, the fund is sold, the gains become realized and are subject to tax.

 Capital Gain is of two types:

 ·         Short term: This is an asset that is sold before 36 months. However, if these assets are held for 12 months or less, they also come in the purview of short term capital gains. 

a)     Units of specified mutual funds.

b)    Securities listed on a recognized stock exchange.

c)     Units of Unit Trust of India.

d)    Equity or preference shares held. 

·         Long term: If an asset is sold or transferred after 36 months from the date of acquisition or transfer, or after 12 months, in case of the specified assets listed above, the gain is said to be long term capital gains. 

Computation of tax on short term and long term capital gains:

Tax Applicable:

For Short term capital gains: The tax rate applicable is as per tax slab of the individual.

For Long Term Capital Gains made: The tax rate is the lower of 10% on the gain or 20% on the gain after considering indexed cost of acquisition (This option is applicable for assets listed above as securities) For property, the tax rate is only 20% on the gain with indexation benefits.

I will explain what indexation is, and how it benefits you, in just a bit…

For Short term Capital gains, the Sale consideration is reduced by the following:

a)     Expenditure incurred in transfer of a capital asset.

b)    Cost of Acquisition.

c)     Cost of Improvement.

For e.g., if an equity fund is purchased in June 2012 for Rs 1 lakh and the same is sold in January 2013 for Rs 105000, the gain is Rs 5000 and the period is 6 months, therefore, short term capital gains is applicable. If you have incurred a cost to acquire this mutual fund, like fees paid of say Rs 1000, the computation of tax is as under:

Computation of capital gains 

Transaction	Value
Sale of Mutual fund	105000
Less: fees paid	1000
Less: Cost of purchase	100000
Capital Gains	4000

The tax rate applicable here, as mentioned, is dependent on the tax slab of the individual. If the individual is in the highest tax slab, the tax applicable would be 30%+ surcharge. 

Ignoring the surcharge calculation (since it is subject to frequent change), the tax paid on the above Rs 4000 is Rs 1200. Hence, the net gain after tax is Rs 2800.

For Long term Capital Gains, there is a concept of indexation, which needs to be understood first with inflation.

The value of a rupee today, is not the same as the value tomorrow. The prices of articles keep increasing every year and you need to pay more for every article over the years. This is due to inflation and the rising cost of articles and the subsequent decrease in purchasing power. As the cost of 1 liter of petrol has risen from Rs 20 in the early 1980’s to Rs 79 in 2012, you need to pay 300% more for the same quantity of one liter of petrol.

Therefore, just as you have incurred a higher cost on purchase of petrol, the government has given the benefit of paying lower capital gains tax by incorporating the effect of inflation on your cost.

Indexation is used to counter the eroding effect of an asset over time, by using an index every year, which inflates the cost of acquisition of the asset by a factor called the Cost Inflation Index, which is published by the Government every year.

Below is the cost inflation index for all the years.

FINANCIAL YEAR	COST INFLATION INDEX
1981-1982	100
1982-1983	109
1983-1984	116
1984-1985	125
1985-1986	133
1986-1987	140
1987-1988	150
1988-1989	161
1989-1990	172
1990-1991	182
1991-1992	199
1992-1993	223
1993-1994	244
1994-1995	259
1995-1996	281
1996-1997	305
1997-1998	331
1998-1999	351
1999-2000	389
2000-2001	406
2001-2002	426
2002-2003	447
2003-2004	463
2004-2005	480
2005-2006	497
2006-2007	519
2007-2008	551
2008-2009	582
2009-2010	632
2010-2011	711
2011-12	785
2012-13	852

Now, let as look at calculating the capital gains on long term capital assets.

Therefore, just like short term capital gains calculation, the calculation for long term capital gains is arrived at taking the sale consideration and reducing by, 

a)     Expenditure used in the transfer of the capital asset.

b)     Indexed Cost of Acquisition.

c)      Indexed cost of improvement.

Therefore, to arrive at the indexed cost of acquisition of an asset for computing long term capital gains, following is the formula:

Sale consideration* Cost inflation index for the year of sale/ cost inflation index for the year of purchase.

Illustrating with an example here would be useful: A property has been purchased for Rs10 lakh in June 2004 and is sold for Rs 20 lakh in Dec 2009.

First, we need to compute whether the gain is short term or long term.

In this case, the asset (property) has been held for more than 3 years. (Dec 2009 - June 2004). The asset is sold after 5 years; hence it is sale of a long term capital asset.

Now to compute the capital gains tax applicable:

We cannot just take Sale Consideration – Purchase cost. Since, this is a long term capital asset, (property) we have to calculate the indexed cost of acquisition.

*Indexed cost of Acquisition in the above example is: 1000000*632(CII for FY of Sale of Asset)/480(CII for FY of Purchase of Asset= Rs 1316666.

In addition, say, there was an agent fee of 2% paid on sale of the asset. Since, this is the expenditure incurred on transfer of the asset; it can be reduced from the sale consideration, to reduce the applicable capital gains tax.

Therefore, using the formula to compute long term capital gains as mentioned above: 

Transaction	Value
Sale Consideration	2000000
Less Expense incurred on sale (agent fees)	40000
Less Indexed cost of Acquisition *	1316666
Total Capital Gains Applicable	643334

This amount has a tax of 20% on it. (Long term capital gains tax)= Rs 128667.

To avoid this tax, there are options, under Sec 54, Sec 54B, Sec 54D, 54EC, 54 F, 54G, depending the type of property sold, where one can claim exemption. This further reduces the incidence of capital gains tax payment.

Therefore, instead of paying tax on 1 lakh, the tax has to be paid only on Rs 6, 43,334, because the indexation benefit has been used to increase the cost of the asset, and thereby reduce the capital gains.

Remember, we need to be first clear on the type of asset sold. If the asset was any of the listed  assets, that fall under the 12 months horizon like shares, mutual fund units, etc, then the option of tax would be 10% flat on the long term capital gains incurred or 20% after the indexation calculation is made, whichever is lower.

In the above example, of property sale after 5 years, only 20% tax is applicable with indexation and the calculation is shown above.

In case, a property has been inherited, the same calculation would be applicable; however, two important points need to be considered in case of cost of acquisition and period for determining the type of capital gains.

The cost of acquisition would be the cost of acquisition incurred by the previous owner before the property has been transferred. The period would be calculated from the date of transfer of asset from the previous owner to the current owner and the date of sale.

Dilshad Billimoria

(Certified Financial Planner and Investment Advisor)

The views expressed in this article are solely of the author and do not necessarily reflect the views of Cafemutual.