If you want to be a smart investor, you cannot view your investments solely on the basis of the returns they can generate. You have to simultaneously check out the tax implications of your investments.
There are questions you need to address, such as, will the investment help in saving taxes, as in the case of public provident fund or an equity-linked savings scheme? Would you have to pay tax on the interest earned?
An investment may seem fantastic, like a fixed deposit with an absolutely great interest rate. But since the interest earned on FDs is taxed, the yield drops. And, if you fall in the highest tax bracket, your returns will be impacted severely. All of a sudden, the investment becomes unattractive. Returns, obviously, are not the only parameter for investments.
Let's take a look at what are the tax implications on a mutual fund investment.
Taxes are applied on mutual funds on the basis of the funds being divided into just two categories - equity and debt. This helps to avoid any sort of confusion. Schemes that invest 65 per cent or more of their entire corpus in domestic equity (shares of companies listed on Indian stock exchanges) are termed as equity schemes. The rest fall into the debt category.
But before we move on, let's talk about one set - asset allocation funds. Being a fund of funds, the tax implication on this category can be confusing. These funds have the mandate to be totally flexible in their asset allocation.
They can move their entire assets into equity, or totally exit it - all at the discretion of the fund manager, or a mathematically computed programme that takes the call. Hence, it is only at the end of the year that one gets to know where these funds have invested their assets and accordingly determine their tax status.
Another category where taxpayers may face some ambiguity with regard to taxation is arbitrage funds. These funds take advantage of a price mismatch between the cash market and the futures market. But the asset allocation may also move between equity and debt, as in the case of UTI SPrEAD. The average debt allocation has been in the vicinity of 68 per cent, while equity has been around 6 per cent (March 2008-August 2008).
As on August 31, 2008, UTI SPrEAD had an equity allocation of 10.56 per cent, while the corresponding figures for JM Arbitrage Advantage and SBI Arbitrage Opportunities were 71.48 per cent and 71 per cent respectively. JP Morgan India Alpha states in its offer document that this arbitrage fund should be treated as a debt fund.
Getting a fix on capital gains
Whenever an investor sells an asset and makes a profit, it is termed as a capital gain (or a capital loss, in case the sale is at a value which is lower than the buying price). The asset could be anything - home, land, stocks, mutual funds, fixed return instruments like fixed deposits, bonds and debentures, and even gold.
The tax levied on this profit is called capital gains tax. This tax is applicable in one of two forms: long-term capital gains, or short-term capital gains, depending on how long you held the asset before its sale.
As far as mutual funds are concerned, LTCG comes into play if you sell your units after holding them for 12 months. But if you sell them within a year of buying, STCG is applicable.
Equity
Both individuals and corporates face the same taxation when it comes to an equity mutual fund. Here, there is no applicable LTCG. But if you were to cash in on your equity mutual fund investment within a year of the purchase, then an STCG tax of 16.99 per cent will be applicable.
This includes the capital gains tax rate as well as the surcharge and cess (15 per cent + 10 per cent + 3 per cent).
Debt
If you sell your debt fund within a year of the investment being made, STCG comes into play. If you sell it after a year, then LTCG is relevant.
One advantage with LTCG is that the income tax authorities give you the option of including the benefit of indexation. This is a process by which inflation is taken into account when doing the tax calculation. This is an excellent advantage because it may reduce the capital gains amount and, consequently, the tax you will end up paying.
Are dividends taxed?
There seems to be a lot of confusion over the dividend distribution tax. It is a tax imposed only on the asset management company and not on the investor. However, the AMC will deduct the dividend tax from the money that will eventually go to investors. So it's the investor that loses out in the end, not the AMC.
Making the right choice
Finally, let's look at the basic dilemma that investors face: Is the growth option more viable than a dividend one? To answer this query, let's assume two scenarios - the first is where the investment is done for a period of less than 12 months, and the second for more than a year. This will enable us to understand the short- and long-term capital gains impact better.