Tax benefits of investing in MFs

Mutual fund investment offers an attractive opportunity to the investor in terms of capital appreciation, liquidity as well as tax benefits.

TAX benefits play a critical role in the investment decisions of the mutual fund investor. In India, the Government also appears to be keen to encourage investment in mutual funds. This will encourage investors from seeking the intermediation of mutual funds in the capital and debt markets, thus bringing in more funds for industry and commerce. Perhaps the Government is also of the opinion that it will be more difficult for the wrong kind of companies to raise money from gullible investors if professional investors like mutual funds are involved in the investment process.

The tax benefits for investing in mutual funds are as follows:

* Under Sec. 10(23D) of the Income-tax Act, a mutual fund is completely exempt from paying taxes on dividends/interest/capital gains earned by it. Even though this is a direct benefit to the fund, the unit holders obviously gain as well.

* Twenty per cent of the amount invested in specified tax savings schemes of mutual funds (called equity linked savings schemes or ELSS) is deductible from the tax payable by the investor in a particular year subject to a maximum of Rs. 2,000 per investor. This benefit is available under Sec. 88 of the Income-tax Act.

The 1999 budget has made the mutual fund investor exempt from paying any tax on the dividend received by him from the mutual fund, irrespective of the type of mutual fund. This benefit is available under Sec. 10(33) of the IT Act. Since investors will be receiving tax-free dividends, the benefits of Sec. 80L are no longer relevant for mutual funds.

A mutual fund has to pay a withholding tax of 10 per cent on the dividends distributed by it under the revised provisions of the 1T Act. In fact, the actual tax will be 11 per cent since the mutual fund must pay a 10 per cent surcharge as well. However, if a mutual fund has invested more than 50 per cent of its assets into equity shares, then it is exempt from paying any tax on the dividend distributed by it, for the next three years. This benefit will give a boost to equity based and balanced funds. On the other hand investors will do well to opt for the growth option in the case of debt based funds.

A few funds have introduced an innovative systematic withdrawal plan wherein investors can leave standing instructions to the fund to redeem a fixed amount every month, to get over the tax problem. The dividend tax on mutual funds is advantageous for investors who otherwise are in the 22 per cent or 33 per cent tax brackets, but unfair to those who are in the zero tax bracket. Those in the nil tax bracket will have to pay by default a 11 per cent tax from dividend income distributed by mutual funds. It must also be remembered that this dividend tax is not like a tax deducted at source (TDS). Unlike TDS, an assessee cannot claim refund from IT authorities under the dividend tax.Investment in eligible securities of the entire proceeds obtained from the sale of capital assets for three years or investment of only the profits for seven years, exempts the asset holder from paying capital gains tax. This benefit is available under Sec. 54EA and 54EB of the IT Act.

The units of mutual funds are treated as capital assets and the investor has to pay capital gains tax on the sale proceeds of mutual fund units sold by him. For investments held for less than one year the tax is equal to 30 per cent of the capital gain plus surcharge. For investments held for more than one year, the tax is equal to 20 per cent of the capital gains plus surcharge. The investor is entitled to indexation benefit while computing capital gains tax.

Thus if a typical growth scheme of an income fund shows a rise of 12 per cent in the net asset value (NAV) after one year and the investor sells it, he will pay a 20 per cent tax on the selling price less cost price inclusive of indexation component. This reduces the incidence of tax considerably. This concession is available under Sec. 48 of the IT Act.

In order to understand the benefit of the concept of indexation, let us assume that an investor has invested 1000 units at an NAV of Rs. 10 per unit, that is, he has invested Rs. 10,000. The NAV grows at, say, 12 per cent during the next 12 months and after one year the NAV is Rs. 11.2 per unit. The value of the original investment has now become Rs. 11,200. The gain for the investor is Rs. 1,200. If we presume an indexation component of 7 per cent, then the indexed cost of the original Rs. 10,000 investment is Rs. 10,700 after one year. Thus the capital gains will be Rs.(11,200 minus 10,700) = Rs. 500. The long term capital gains tax being 22 per cent would lead to the investor paying a capital gains tax of Rs. 500 at 22 per cent, that is, Rs. 110. A tax amount of Rs. 110 on a total gain of Rs. 1,200 means a tax rate of 9.16 per cent irrespective of the tax bracket of the investor. This tax may also be avoided by either investing the entire amount of the realised value, that is, Rs. 11,200 for three years in eligible securities under Sec. 54EA or the capital gains amount of Rs. 500 in eligible securities for seven years under Sec. 54EB.

The above tax benefits make it clear that mutual fund investment today offers a very attractive investment opportunity to the investor in terms of capital appreciation, liquidity as well as tax benefits. The investor has only to identify the right type of mutual fund in which he can repose faith.

Abhijit Roy

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