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ETF Taxation: A Guide to Dividends, Capital Gains, and Tax Implications

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Published Date: 26 Nov 2024Updated Date: 30 Dec 20246 mins readBy MOFSL

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Introduction

Exchange Traded Funds (ETFs) have gained immense popularity in India over the past few years. They offer the flexibility of investing in various assets, such as equities or bonds, and are traded on the stock exchanges. To optimally benefit from their potential, it is important to understand how taxes apply to dividends, capital gains, and other aspects of exchange-traded funds. This guide breaks down everything you need to know about ETF taxation.

What is ETF taxation?

ETF taxation pertains to tax levied on the income and gains generated by ETFs under Indian law. Since ETFs differ from traditional mutual funds, they follow distinctive tax rules that vary depending on the type of ETF. This means it differs for equity-based, debt-based, and other ETFs.

There are two types of tax on ETFs. One gets subjected to the capital gains or profits from buying and selling shares. The other is taxation on dividends from ETFs. It depends on the funds and whether they distribute income.

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Types of ETFs and their tax treatment

As discussed, different types of ETFs attract different tax rates due to their underlying assets. Here's a closer look at the common ETF categories and how they're taxed.

· Equity ETFs

Equity ETFs primarily invest in stocks. Similar to equity shares, they are subject to short-term and long-term capital gains,

· Debt ETFs

Debt ETFs invest in fixed-income assets. This includes government bonds or corporate bonds. They are also taxed on capital gains, but different from equity shares, and they involve indexation benefits.

· Gold ETFs

Gold ETFs track the price of gold and are taxed as non-equity investments. They are taxed differently based on short-term and long-term capital gains.

· International ETFs

ETFs that invest in foreign markets are treated as international ETFs. They are treated like non-equity funds. This means a different tax treatment is applicable than applicable to domestic equity ETFs.

Tax on ETF dividends

Previously, dividends from ETFs were subject to a Dividend Distribution Tax (DDT) of 15% on dividends paid to you. However, the changes in the Union Budget of 2020 abolished DDT. Hence, dividends are now taxable as per your applicable tax slab rate. Here's how a tax on ETF dividends works today:

· Dividend and income: Dividends from ETFs are now a part of your income. Thus, they are taxed as per your income tax slab.

· Tax computation: Dividends are classified under the "other income" category where you compute your tax liabilities for the year.

Taxation on Capital Gains from ETF

The tax on ETF capital gains depends on the type of ETF and the holding period. For easy understanding, here's a look at how capital gains tax applies to equity and non-equity ETFs:

· For Equity ETFs:

If equity funds are sold within a year, they are subject to a short-term capital gains tax of 15%. If you hold them for more than a year, you incur taxation on the long-term capital gains of 10% for the amount exceeding Rs. 1 lakh. This is without the benefit of indexation.

· For Non-Equity ETFs (Debt and Gold ETFs:

If you sell the non-equity ETFs within three years, you benefit from short-term capital gains and they get taxed as per your income tax slab. When non-equity ETFs are held over three years, you incur 20% on the long-term capital gains with indexation benefits. This considerably reduces your tax liability.

Key Points to Know About Exchange-Traded Fund Taxation

Here are some key factors related to ETF taxation you should make a note of to make informed investment decisions:

· Tax loss harvesting

If you have witnessed losses in other investments, you can sell units of ETF with gains to offset your tax liability. This strategy is known as tax loss harvesting, and it helps reduce your overall capital gains tax.

· Indexation

When investing in non-equity ETFs, such as gold and debt ETFs, you can take advantage of the indexation benefit on long-term gains to reduce taxes. Indexation adjusts the purchase price of the asset to account for inflation.

· Tax policies

Tax policies keep changing with new reforms in the Union Budget and RBI regulations. Hence, the tax and indexation benefits applicable today might not be the same tomorrow. It is important to stay updated with the recent tax policies to account for such changes.

Conclusion

ETF taxation is a critical aspect to consider when you invest in Exchange-Traded Funds. Understanding tax implications on dividends, capital gains, and indexation can empower you to make more tax-conscious investment decisions. With tax implications taken care of, you can optimally benefit from the diversification and flexibility that ETFs offer. Be mindful of how different types of ETFs are taxed, and consider factors such as updated tax policies, indexation, and tax loss harvesting when tax planning on your ETF investments.