Before investing in any financial instrument, the first thing we check is the returns. We are more concerned about the profit that we overlook the tax we have to pay. No one likes unpleasant surprises, and tax on returns can be one if you don’t know how much tax you have to pay on the profit you make. In mutual funds, equity and debt funds are taxed differently. This article will cover the calculation of long-term capital gain on debt mutual funds in detail.
Debt funds are mutual funds that invest in debt securities such as money market instruments, government bonds, and corporate bonds. They give predictable and stable returns and are best suited for investors with short-term goals and low-risk tolerance.
The returns you earn on debt mutual funds can either be in the form of interest or capital appreciation. Interest is the fixed return, whereas capital appreciation is the increase in the value of the fund due to market dynamics. These are called capital gains, and based on how long you hold them, capital gains are categorized as short-term and long-term.
Short-term capital gains are profits earned within three years from the date of investment. Long-term capital gains, on the other hand, are profits earned after three years from the date of investment. Both short-term and long-term gains are taxed differently. You will be liable to pay tax on capital gains only when you sell your mutual fund investment.
Short-term capital gains are taxed as per your income tax slab rate. So, if you sell your debt mutual funds before 36 months from the date of investment, your capital gains will be added to your income and taxed accordingly.
You will have to pay long-term capital gains if you sell the investment after 36 months. The long-term capital gains are taxed at 10% without indexation benefits and 20% with indexation benefits.
The dividends distributed by the fund house are also taxable. They are taxable at the investor’s income tax slab rate. Moreover, dividends beyond Rs 5,00 are subject to a TDS (Tax Deducted at Source) of 10%.
Indexation is adjusting the value of investments through a price index so that your purchasing power is maintained post-inflation. With indexation, you can also reduce your tax burden. You can inflate the purchase price so that the gap between your purchase and sale price is reduced, lowering your taxable returns and tax liability.
Indexation applies to long-term investments. With indexation, you can reduce your long-term capital gains and pay less tax. In mutual funds, indexation applies only to debt mutual funds.
To calculate the indexed cost of acquisition, you will have to adjust the original cost using the price index. The formula for calculating the indexed cost of acquisition is given below.
Indexed cost of acquisition = Original cost * (CII of the year of sale/CII of year of purchase),
Where, CII is the cost inflation index, and the data is readily available on the income tax website.
Let’s see how indexation will help reduce capital gains with the help of an example.
Assume you had invested Rs 150,000 in a debt fund when the NAV was Rs 20 in 2016 and sold it after four years in 2020 when the NAV is Rs 25. Let’s see how to calculate the capital gains with indexation benefit and tax liability.
The number of units you will get is 7,500 (Rs 150000/20)
The capital gain per unit is Rs 5 (Rs 25-20)
, and the total gain is Rs 37,500.
But since you have invested for more than three years, you are eligible for an indexation benefit.
Though it is optional, it is best to take the indexation benefit, as this will reduce your tax burden.
To get an indexation benefit, we must first calculate the indexed cost of acquisition. The CII for 2016 is 254, and for 2022 is 289.
Indexed cost of acquisition = 20 * (289/254)
Indexed cost of acquisition = Rs 22.76
The indexed long-term gain is Rs 2.24 (Rs 25-22.76), and the total gain now is Rs 16,830.7. These are taxable gains and will be taxed at 20%. Hence your tax liability is Rs 3,366.
Indexation benefit will help you reduce your taxable capital gains and hence your tax liability. In the above example, the capital gains before indexation are Rs 37,500, and after indexation, Rs 16,830.
The capital gains were reduced by a whooping Rs 20,669, reducing your tax liability by Rs 383. So, your post-tax returns will be Rs 34,134 (Rs 37,500-3,366). The higher you invest, the more will be the gap in tax liability, and the higher will be your post-tax returns.
Let’s assume you invested Rs 15,00,000 instead. The following will be your capital gains and tax liability with and without indexation benefit.
|With Indexation||Without Indexation|
|Capital gains||Rs 168,307||Rs 375,000|
|Tax liability||Rs 33,661||Rs 37,500|
|Post-tax returns||Rs 3,41,339||Rs 3,37,500|
It is clear that you can reduce your tax liability and get higher post-tax returns with indexation.
Long-term capital gains for debt mutual funds are taxed at 10% without indexation and 20% with indexation benefit.
Short-term capital gains for debt mutual funds are added to the investor’s income and taxed at the investor’s income tax slab rate.
The long-term capital gains for debt mutual funds are taxable under Section 112 of the Income Tax Act 1961. In the case of dividends, they are covered under Section 115R of the Income Tax Act 1961.
Capital gains from debt mutual funds are not subject to TDS for Indian investors. However, in the case of NRIs, there is a TDS on capital gains of 30% for short-term capital gains and 20% with indexation benefits for long-term capital gains. The dividends paid to resident and non-resident Indian investors are also subject to a TDS of 10% for dividends in excess of Rs 5,000.
Mutual fund dividends are taxable in the hands of investors at their slab rate. However, dividends up to Rs 5,000 do not attract a TDS of 10%. For dividends beyond Rs 5,000, there is a TDS of 10% applicable.
As per the Finance Act 2018, grandfathering is only applicable to equity mutual funds. This is because the long-term capital gains for equity funds were tax-free until 31st January 2018. But when the government introduced a tax of 10% for gains beyond Rs 1 lakh on equity funds, grandfathering of gains applies to investments done before the date mentioned above.