Here’s How The New Three-Tiered Taxation Of Mutual Funds Works

The change in the taxation norms for mutual funds has led to some confusion about the tax treatment of some mutual fund schemes. There is now a three-tiered tax system, which means that there are three distinct groups based on how taxes are treated.

Earlier, only two categories existed. And if a mutual fund scheme did not attract equity-like taxation, it automatically attracted the second type of taxation. Here’s a look at the new categorisation:

Equity Exposure More Than 65%

The first category of taxation covers funds that have predominantly domestic equity holdings. When taxation is being determined, there are two things that must be considered. One is the condition that needs to be fulfilled, and the other is the rate that is applicable to the specific funds that qualify in a specific category.

Those schemes with a predominantly equity exposure will be taxed similarly to equity shares. These are all the mutual fund schemes that have an average exposure of at least 65% to domestic companies in their portfolio. This means that any fund with an exposure of 65% or more on average for the entire year will be classified as an equity-oriented fund, though there could be small time periods during the year when the equity exposure might fall below this figure.

For these funds, the holding period for demarcation as a long-term capital asset is one year, and if the holding is below this period, it would be classified as a short-term capital asset. There are concessional rates of tax for both types of capital gains. For short-term capital gains, the applicable tax rate is 15%, while for long-term capital gains, the applicable rate is 10%. If there is a short-term capital loss, then it can be set off either against a short-term capital gain or a long-term capital gain, but a long-term capital loss can be set off only against a long-term capital gain.

Equity Exposure Less Than 35%

A second category, which will have a different tax treatment, consists of those funds that have a holding of domestic equities that is less than 35% on average during the year. This will include all the debt funds plus gold funds and even pure international funds, since none of these categories have a domestic equity exposure of 35% or more. Some hybrid funds will also fall into this category. Here, the calculation is pretty simple because there is no distinction in terms of the gains that are made.

All the gains from such funds will be classified as short-term capital gains, no matter how long the holding period. This means that the gains from such investments will be taxed at an individual’s income tax slab rate.

Here too, the short-term capital gains can be set off against other short-term capital gains or long-term capital gains.

Equity Between 35% And 65%

Those funds where the equity exposure during the year is between 35% and 65% will fall into a separate category—the one that used to include debt mutual funds. There will be several hybrid funds where the holdings of domestic equities during the year will be more than 35% but less than 65%.

In these cases, the holding period for the classification of either a short-term capital gain or a long-term capital gain will be three years. If the gain is a short-term capital gain, then it will be taxed at the marginal tax rate applicable to the individual based on their income. However, if there is a long-term capital gain, the rate of taxation will be 20% with indexation benefits. That means that the gains are adjusted for inflation and then taxed.

The writer is founder, Moneyeduschool

The views expressed here are those of the author, and do not necessarily represent the views of BQ Prime or its editorial team.