Introduction

FIFO, or First In, First Out, refers to the treatment of how your redemptions are taxed under the Income-tax Act, 1961. Understanding the implications of FIFO and its potential impact on your returns helps avoid any negative surprises when you file your Income Tax Return (ITR). This overview will provide meaningful information to remove any guesswork with FIFO and provide absolute clarity and ideas to keep you compliant and tax-efficient.

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What is FIFO?

FIFO or First In, First Out refers to the structure whereby the mutual fund units purchased before the other units are deemed to be sold first in the context of your redemption. The NSDL and CDSL depositories prescribe this FIFO treatment to uniformly compute tax liabilities and net realisable holdings. If you redeem mutual fund units, FIFO is designed to prevent you from cherry-picking newly purchased units to avoid taxes, which aligns with CBDT's guidelines for fair tax reporting.

Importance of FIFO for Investors

Due to your situation, FIFO defines the holding period of your units, determining if the gains are Short-Term Capital Gains (STCG) or Long-Term Capital Gains (LTCG).

• Equity-oriented funds

  • Short-Term Capital Gain (STCG) tax at a rate of 20% will apply to the units if they are held for 12 months or less.

  • Long-Term Capital Gains (LTCG) where the units have been held more than 12 months and the gain exceeds ₹1.25 lakh, then the taxation is at a 12.5% level.

• Debt funds after April 2023

  • Short-term gains are included in your income and taxed at slab rates

  • Long-term gains (held >36 months) are taxed with indexation benefits.

Misreading FIFO could lead to misreporting your gains on your capital gain slip and a tax notice from the income tax department.

How FIFO Works In Your Demat Account

FIFO System Demonstrated

When you redeem a unit, FIFO matches the shares to your oldest purchases. Consider this FIFO method example:

January 2024: You purchase 200 units at ₹50 on NAV.

July 2024: You add 200 units at ₹60 NAV.

September 2025: You redeem 250 units at ₹70 NAV.

First 200 units from January 2024 held for 19 months (LTCG=200× ₹20=₹4,000, taxed at 12.5% on all gains exceeding ₹1.25 lakh in this financial year). The next 50 come from July 2024 (14 months, LTCG: 50 × ₹10 = ₹500 gain).

Each lot's profits are taxed separately according to FIFO. The long-term capital gain (LTCG) on units purchased in January is calculated separately, while units purchased in July could be short-term capital gain (STCG) or long-term capital gain (LTCG), depending on whether they have exceeded the one-year holding period. There is no blended LTCG rate.

Cost Accounting FIFO Method

Think of FIFO as a cost accounting FIFO method, akin to inventory tracking. It assumes the earliest costs (your first units) are realised first, fixing the acquisition cost and date for tax purposes. This confirms that your Demat units will adhere to a sequence, regardless of their ability to be exchanged for one another, when calculating gains.

FIFO Problems and Solutions

Common Problems with FIFO

SIP Complication: Each Systematic Investment Plan (SIP) instalment gets classified as a new first-in. Redeeming a lump sum also pulls from older units first and could result in short-term capital gains (STCG) when looking for long-term capital gains (LTCG).

Corporate Actions: Regarding bonus units or fund mergers, the newly acquired units retain the holding period of your original shares unless you make a different electoral decision, which could alter your cost basis.

Your Tax Rate: Selling some holdings for cash could result in redeeming older units first, meaning STCG in stead of LTCG tax rates for you.

Solutions to FIFO

Dedicated Folios: FIFO applies to each folio separately. If you have multiple folios of the same scheme, FIFO is not automatically aggregated across the folios. Individual folios allow you to prioritise your short-term versus long-term plan more appropriately.

Timing Redemptions: Wait until your units are over 12 months old to receive equity fund LTCG benefits.

Utilise Brokerage Platforms: Use your broker's platforms to obtain gain statements on a FIFO basis; this can also simplify the ITR filing.

Tax-Loss Harvesting: This option may make sense to sell during market drops to realise losses, and purchasing FIFO allows for an easier way to first wheel away the older stocks.

The Legal Foundation of FIFO

FIFO is not simply an option; it is based on:

1) CBDT Circular No.704 (1995) requires FIFO to sell securities.

2) The Securities and Depositories Act, 1996 - The Act provides for transactions on a Demat account to follow FIFO.

3) The Income Tax Act, 1961, requires the cost of acquisition and holding period to be determined in FIFO.

Remember that your risk profile can be raised if you do not follow FIFO, especially as tax returns are made available to the tax portals. This can match the data from the Automated Mutual Fund Companies and Depositories.

Conclusion

FIFO is not only an accounting method but also a tax compliance methodology and method for thoughtful investing. When you know FIFO, you will analyse your redemptions, create tax savings potential, and find an issue with the ITR. As India shifts toward a more automated and data-driven tax regime, accuracy around the FIFO method will grow in importance. So, look at your portfolio, ensure you have applied for FIFO, and confidently prepare your taxes.

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