How your mutual fund investments are taxed: Business Line,

Gains from equity funds and debt funds are taxed differently, while systematic investment plans come with their own intricacies.

After missing the July 31 deadline, Krish, a software engineer, managed to file his income tax return last week. He met up with his cousin Raj, a student chartered accountant on Saturday.

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Krish: Hi Raj. How are your studies coming along? You will be taking the final exams this November, isn’t it?

Raj: Don’t ask. We trainees have had such a hectic time helping clients file their returns. The extension of deadline to August 31 has done more damage to our study schedule.

Krish: What to do! Tax laws are so complicated that we all need your help.

The other day, I spent quite a bit of time with my auditor sorting out issues related to my mutual fund investments. Even now, I am not very clear about the tax treatment.

Raj: It is not difficult Krish. Broadly, there are two types of mutual funds — equity and debt funds; and two kinds of taxes — long-term and short-term capital gains (LTCG and STCG).

Typically, STCG in funds arise if you sell the investment within one year of buying it. For equity funds, the STCG tax is a flat 15 per cent. STCG on sale of investment in debt funds is taxed in the slab in which you normally fall.If you have held the investment for more than a year, then the gains become long-term.

For equity funds, LTCG is tax-free. But LTCG is still taxed in case of debt funds at 10-20 per cent depending on whether you use indexation benefit.

Krish: If LTCG on sale of equity funds is tax-free, then how did my auditor tell me I had to pay tax? I sold my investment in HDFC Top 200 fund in December 2011. But it has been more than a year since I invested.

Raj: Was your investment one-time or was it a Systematic Investment Plan (SIP)?

Krish: It is an SIP. I set up an auto-debit for Rs 2,500 every month to buy units of HDFC Top 200 since September 2010.

Raj: That’s why. To be tax free, every instalment of your SIP should have completed one year when you sold.

According to the law, the units you purchased first will automatically be the first to be redeemed. As on December 2011, only the first 3-4 instalments would have completed one year.

Krish: Little wonder that I had to pay capital gains tax. I did not know this.

I also have another doubt. I invest in ELSS (Equity Linked Savings Schemes) schemes every year because of the section 80C benefit. Is this one year limit applicable for ELSS too?

Raj: These schemes have a lock-in of three years as you enjoy tax deduction under section 80C in the year of investment. So sale after the three years period will qualify as LTCG and be exempt.

Similarly, if you are doing an SIP in an ELSS fund, each instalment should have completed three years before you sell. In both cases, if you sell within the lock-in, the amount that you originally claimed as deduction under Sec 80C for investing in these funds will be reversed.

Krish: That’s a revelation! But see, in all these cases, I gain only if the fund is performing well.

What if I sell a fund that is performing badly? I sell it because I don’t want to erode my capital further. Certainly, losses can’t be taxed.

Raj: Yes. For example, if you sell your holding within a one year period and you make a loss, this is a short-term capital loss. You don’t pay tax on this loss, definitely.

Secondly, you can set off this loss against any other short or long-term capital gains that you make. But if you make a long-term capital loss on an equity fund, for instance, you cannot avail the set off as the gain itself is originally exempt from tax.

Krish: See the intricacies! And you are telling me tax laws are not complicated!

However, one thing I am clear about is dividends. I remember putting the dividend amount in a column called ‘exempt income’ in the I-T return.

Dividends are not taxed, is it not?

Raj: Yes sir. Whether it is an equity or debt fund, the dividend is not taxed in your hands. But there is a catch.

For debt funds, fund houses need to pay a dividend distribution tax. This tax is indirectly borne by you, thereby reducing you dividend inflow to that extent.