How are liquid funds and debt funds taxed - Motilal Oswal

How are liquid funds and debt funds taxed?

For the purpose of taxation of mutual funds, the broad distinction is only between equity and non-equity funds. Equity funds are those who have an exposure of at least 65% to equities. So, equity diversified funds, balanced funds with 65% exposure to equities, arbitrage funds are all classified as equity funds for tax purposes. Other than these, all the other funds are classified at debt funds for the purpose of tax. Thus debt funds, Fixed Maturity Plans (FMPs), MIPs, liquid funds, short term funds, Fund of Funds, Gold Funds are all classified as non-equity funds for the purpose of taxation. Both liquid funds and debt funds are taxed as non-equity funds and hence their method of taxation is exactly the same. Let us understand how are a debt fund taxed and the tax implications of liquid mutual funds investment. Here are 4 key facts about liquid funds vs debt funds taxation..

1.  Taxation of dividends in case of debt funds and liquid funds..
As you are aware, when you invest in these debt funds or liquid funds you can opt for a growth plan or a dividend plan. A dividend plan involves payout out a part of the profits and income earned by the fund to its fund holders. So how are dividends paid out by debt funds and liquid funds taxed? Here are 2 points to remember..

The dividends paid out by the debt fund or liquid fund are entirely tax free in the hands of the fund investor. This is an advantage that continues and to that extent it is a better option compared to a pure debt instrument.

However, there is a dividend distribution tax (DDT) that is deducted by the fund at the time of paying out dividends. In case of debt funds and liquid funds this rate is 28.84%, which is a small advantage compared to the peak rate of tax that is payable on pure debt instruments like FDs.

2.  Taxation of capital gains in case of debt funds and liquid funds..
The taxation of capital gains differs in case of debt funds and liquid funds compared to equity funds. Since debt funds and liquid funds are classified as non-equity funds, their treatment of capital gains is the same. Here are 3 points to understand..

The cut-off period for long term capital gains in case of debt funds is 36 months. If the debt fund is held for a period of up to 36 months then it will be classified as short term capital gains and if it is held for more than 36 months then it is LTCG.

Long term capital gains on debt funds and liquid funds are taxed at 20% after considering the impact of indexation. This substantially reduces the impact of tax on long term gains on debt funds.

In case of short term gains, the debt funds and liquid funds will have the gains added to the total regular income of the investors and will be taxed at the peak rate. If you are in the 30% tax bracket then you pay tax at 30% and if you are in the 20% tax bracket then you pay tax at the rate of 20%.

3.  Understanding the power of Triple+1 indexation for debt funds..
All debt funds and liquid funds are given the status of long term capital gains if the fund is held for a period of more than 3 years. But did you know that you can actually get the benefit of Triple+1 indexation by timing your entry and exit into a debt fund and also by holding the fund for a little longer than 36 months. Here is how..

Debt Fund of XYZ AMCDetailsIndex Value (IT Act)Rs.100.000 on 28th Mar 2014Buying NAV Rs.25.00Index value 2013-14 - 220Units bought 100,000/254000 units Redemption on 3 April 2017Selling NAV of Rs.34.19Index Value 2017-18 - 272Redemption Value – 136,760  LTCG =  (136760 - 100000)Rs.36,760/- Calculating Indexed Cost of AcquisitionCost of acquisitionRs.100,000 Indexation factor (272/220)1.236 Indexed cost of acquisitionRs.123,600 LTCG after indexation(136,760 – 123,600)= Rs.13,160LTCG Tax Payable at…20% of LTCG after indexation20% of 13,160  Rs.2,632Effective Tax Paid2,632 / 36,670= 7.18%

There are 3 key points to understand here..

By timing the purchase around the end of the fiscal year 2013-14 and timing the sale around the beginning of fiscal year 2017-18, you get indexation benefit for 4 years by holding on to the fund for just 6 days more than the 3-year cut off

This additional indexation brings down the effective tax paid on capital gains to around 7.18%, which is much lower than the actual impact of 20% that is payable on long term capital gains on debt funds.

By timing your purchase and sales of debt funds you can substantially enhance your post tax returns on debt funds. This is something you need to remember and plan appropriately

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