Taxation on debt mutual funds: How does it work?

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Taxation on debt mutual funds: How does it work?

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What’s the one important thing you should check before you put your money in a debt mutual fund? Well, the taxation of debt mutual funds, of course. 

Although the answer to this question may vary from one person to another, I think it’s important to check how your returns from that investment will be taxed. That way, you’re not in for a rude shock later. 

While most investors may be aware of how FD interest or equity gains may be taxed, the taxation of debt mutual funds continues to remain quite under the radar. So, why don’t we take a closer look at how your debt fund investments are taxed? 

What kind of returns do debt mutual funds offer?

To understand how taxation of debt mutual funds works, we need to first get a better idea of the kind of returns that you can get from this investment option. You can earn two kinds of returns from a debt mutual fund — dividends and capital gains.

  • Dividends 

Mutual fund companies may pay out a part of the profits they make in the form of dividends. So, if you hold debt mutual funds in your portfolio, and if that mutual fund company pays dividends, you will receive these benefits too. 

Dividends are usually paid out on a per unit basis. For instance, say your mutual fund house pays a dividend of Rs. 5 per unit of a debt mutual fund scheme. In that case, if you hold 1,000 units, you will receive a dividend of Rs. 5,000. 

  • Capital gains

Depending on your purchase price and your selling price, you may earn capital gains when you liquidate your debt fund holdings. For example, say you purchased 10,000 units of a debt fund at an NAV of Rs. 10 each. So, you invested a total of Rs. 1,00,000 in the fund. And later, you sell the holdings when the NAV is Rs. 15 per unit. 

This means you earn a profit of Rs. 5 per unit, or Rs. 50,000 in total.

The Income Tax Act, 1961, treats this profit as a capital gain because your debt fund investments are capital assets. And the taxation provisions will depend on whether these are Short Term Capital Gains (STCG) or Long Term Capital Gains (LTCG).

Taxation of debt mutual funds: How are dividends taxed?

Dividends from debt mutual funds were originally tax-free, up to March 31, 2020. This is because the burden of taxation was borne by the dividend-paying company, i.e. the mutual fund house, in the form of Dividend Distribution Tax (DDT). 

However, Budget 2020 brought in amendments that did away with DDT and shifted the onus of taxation onto the dividend receiver. So, as things stand now, you need to pay tax on the dividends you receive from your debt mutual funds. 

The dividends are added to your overall income and are taxed at the slab rate applicable to you. So, if you fall under the 20% income tax slab, you need to pay tax on the dividends at this rate.

Taxation of debt mutual funds: How are capital gains taxed?

Capital gains from debt mutual funds can be short term or long term, depending on the holding period. Let me explain further. 

  • Short Term Capital Gains (STCG) 

If you sell your debt mutual fund holdings within 3 years of purchase, the profits are considered to be STCG. Similarly, in case of any loss, that would be termed as a Short Term Capital Loss (STCL).

STCG is taxed at your income tax slab rate. For example, if you sell your debt investments within 2 years of purchase at a profit of Rs. 1 lakh, and if your income tax slab rate is 20%, you will have to pay tax at this rate. The cess and surcharge, if any, will be applicable as usual.

  • Long Term Capital Gains (LTCG)

If you hold your debt fund investments for more than 3 years and then sell them at a profit, the gains are LTCG. Similarly, the losses would be termed as Long Term Capital Loss (LTCL).

LTCG is taxed at a flat rate of 20%, after accounting for indexation benefits. This rate is applicable irrespective of what your income tax slab rate is, since LTCG is not clubbed with the rest of your earnings or income.

How does indexation work in the taxation of debt mutual funds?

If you hold your investments over the long term, the gains you make can be partly attributed to inflation. This is because inflation results in an increase in the prices of most goods and services. And it is not fair to tax you for the gains that can be traced back to inflation.

So, the Income Tax Act, 1961, offers the benefit of indexation. It is simply the process by which your purchase price is adjusted to account for inflation. In other words, your purchase price is increased to reflect the cost of your investment — if it was to be made today. 

Let me give you an example for more clarity. Consider the following information:

Particulars

No. of Units

NAV per unit

Transaction value

Date of transaction 

Financial Year

Purchase

10,000

Rs. 10

Rs. 1,00,000

April 10, 2015

2015-16

Sale

10,000

Rs. 15

Rs. 1,50,000

April 10, 2022

2022-23

Here, your gains at first glance will appear to be Rs. 50,000. But your purchase price reflects the cost as it was 7 years ago. It is not adjusted to the present. The same investment will cost more today. So, you need to use a factor known as the Cost Inflation Index (CII) to adjust the investment cost. 

The Central Government notifies the cost inflation index for each financial year in the official gazette. This is what the formula for the indexed or the adjusted purchase price looks like:

Indexed Purchase Price = (CII of year of sale ÷ CII of year of purchase) x (Purchase cost)

So, in the above case, the CII for 2015-16 is 254, and the CII for 2022-23 is 331. Putting this into the formula, you get the indexed purchase price as Rs. 1,30,315.

This means your capital gains after indexation come out to be just Rs. 19,685 (Rs. 1,50,000 minus Rs. Rs. 1,30,315).

And your taxes, at 20% on the gains, turn out to be just Rs. 3,937.

NRI taxation on debt mutual funds

If you are a Non-Resident Indian (NRI) who has invested in India, you may be wondering how your capital gains and dividends are taxed. Well, I’ve got some news for you. NRI taxation of debt mutual funds works exactly like it does for resident Indians. 

So, your dividends and STCG will be taxed at your income tax slab rate, while your LTCG will be taxed at 20% with indexation benefits. 

Summing up

This sums up how taxation of debt mutual funds works in case of dividends and capital gains. If you have debt funds in your portfolio, or if you are planning to invest in this asset class, make sure that you factor in the taxes. That way, you can get a better idea of the true returns from your debt fund investments. 

Frequently Asked Questions (FAQs)

1. How do you calculate tax on debt funds?

The tax on debt mutual funds is calculated as per the rate of tax applicable. In case of Short Term Capital Gains, the profits are taxed at your income tax slab rate. In case of Long Term Capital Gains, the profits are taxed at 20%, with surcharge, cess and indexation benefits. 

2. How can I save capital gains tax on debt mutual funds?

You can make use of the indexation benefits that are available for taxation of mutual funds. This ensures that your gains are adjusted for inflation, thereby making your tax liability more reasonable. However, bear in mind that indexation benefits are only available for long term capital gains on debt funds.

3. Do you have to pay taxes on debt mutual funds?

Yes, you need to pay taxes on the gains you receive from debt mutual funds. These gains are considered as short term or long term capital gains, depending on the period of holding, and are taxed accordingly.

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