Nowadays it is quite common for investors to ask why they cannot do a SIP on direct equities instead of equity funds. While there is the issue of diversification and expert guidance in mutual funds there are also some subtle differences in the way tax treatment is accorded. When we look at equity versus mutual fund considerations, we need to look at diversification, expertise and the tax aspects. How are mutual funds taxed in general and specifically how equity funds are taxed? Taxation of mutual funds in India broadly conforms to the way the underlying instruments are taxed. However, there are subtle differences in the taxation methodology. Before looking at the taxation differences in equity versus mutual fund, let us first look at the similarities of how equity and equity funds are taxed in India..
Similarities in taxation: Equity and equity funds..
There are a lot of similarities in the way an equity share and an equity fund are taxed in the hands of the investor. Let us consider the following broad points…
Dividends in the hands of the investors in equities and equity funds are entirely tax-free. Dividends paid out by equities up to a limit and dividends paid out by equity funds are entirely tax-free in the hands of the investor. In case of equities, there is a dividend distribution tax (DDT) that is deducted by the company declaring the dividend. However, since the company declaring the dividend has already paid the DDT, the mutual fund does not again deduct the tax to avoid double taxation.
Long term capital gains are defined similarly in case of equity and equity funds. Any equity or equity fund held for a period of more than 1 year will qualify as long term capital gains and will be entirely tax free in the hands of the investor.
Short term capital gains in case of equity and equity funds will be taxed at the concessional rate of 15% if it is held for a period of less than 1 year. Taxation of mutual funds in India are similar to the underlying asset in case of equity and in case of debt.
How tax treatment differs: The case of ELSS..
One of the ways in which the taxation of direct equities and equity funds is different is in the case of ELSS funds. ELSS funds are a unique class of equity mutual funds wherein the investor can get additional benefit of tax exemption subject to a lock in period of 3 years. ELSS funds are exactly like equity funds in terms of their asset mix. The only difference is the compulsory lock-in period of 3 years. Investing in ELSS funds (tax saving funds) entitles you to an exemption up to a maximum limit of Rs.150,000 per year from your total income. Of course, this benefit under Section 80C is not exclusively for ELSS funds alone. This limit of Rs.150,000 is shared with other instruments like provident fund, life insurance, home loan principal, long term FDs etc. There are no such special tax benefits available in case of equities.
Taxation of dividends on High Net Worth (HNW) equity investors..
In the previous Union Budget, the government of India introduced a new provision with respect to taxation on dividends. While dividends received on equity funds are tax-free without any limits, dividends on direct equities are tax-free only up to a limit of Rs.1 million (10 lakh) in a financial year. Any dividend received beyond this limit will be shown as Extra Dividend and taxed at a special rate of 10%. The idea is to make taxation slightly more progressive but instead this has encouraged companies to reward their shareholders through buyback of shares rather than through larger dividends. This is another area where equity mutual funds hold an advantage in taxation terms over direct equities.
Taxation of mutual funds in India with reference to debt funds…
When we compare equity with equity funds, there is a very unique tax advantage that debt mutual funds have compared to direct debt instruments. When you invest in a debt instrument, the interest received on debt is fully taxable at your peak rate (unless it is a tax-free bond). Additionally capital gains are also taxable on these bonds. However, debt funds are amenable to a smarter structuring. Remember, you can opt for the dividend option of a debt fund wherein the dividend received by you will be entirely tax-free in your hands. Thus you can convert taxable flows in a bond into tax-free flows in case of a debt fund. However, it needs to be remembered that debt fund dividends are subjecting to dividend distribution tax.
When you understand how are mutual funds taxed in India (equity and debt), it gives you sharp insights about its relative advantages over pure equities and pure debt. The choice is entirely yours!
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