Mutual Funds Sahi Hai - Tax perspective?

I’m sure most of you’ll must be aware of the "Mutual Funds Sahi Hai” media campaign launched by the Mutual Fund industry to create large scale investor awareness about mutual fund investments. The media campaign has been so successful that the industry has been able to attract lakhs of new investors and has witnessed rise in the Assets Under Management (AUM).

What is a mutual fund?

In simple words, a mutual fund is essentially a pooling vehicle which collects money contributed by investors and invests the money in securities like shares, bonds, money market instruments and other assets based on its pre-defined investment objective. Mutual funds are managed by a group of investment professionals employed by Asset Management Companies who charge a small fee for their services.

Investors typically earn returns from a mutual fund in 2 ways - (a) Distribution income [commonly known as dividend income] and (b) Capital Gains. This article provides a summary of the applicable tax rates on these income streams under the Income-tax Act, 1961 (Act) and also highlights some of the key takeaways / issues arising on account of amendments made by the Finance Act, 2020.

(A) Taxation in the hands of resident investors

Tax rates

*Tax rates to be increased by applicable surcharge and cess

#Exempt up to INR 1,00,000 per annum, subject to conditions

Tax withholding by Mutual Fund

^ TDS rate is reduced to 7.5% for the period from May 14, 2020 to March 31, 2021 vide CBDT Press Release dated May 13, 2020. Legislative amendment in this regard is awaited

Relaxation from tax withholding

(1) A person (not being a company or firm) can submit Form No. 15G for non-deduction of TDS

(2) A resident individual (aged 60 years or more) can submit Form No. 15H for non-deduction of TDS

(3) A resident investor can make an application to the income-tax authorities under section 197 of the Act for obtaining a certificate for lower / non-deduction of TDS

(B) Taxation in the hands of non-resident investors (excluding FPIs)

Tax rates

*Tax rates to be increased by applicable surcharge and cess

#Exempt up to INR 1,00,000 per annum, subject to conditions

Tax withholding by Mutual Fund

$TDS rates to be increased by applicable surcharge and cess

@TDS related provisions for capital gains explained in detail later in the article

(C) Key takeaways / issues on account of amendments made by Finance Act, 2020

(1) Growth vs Dividend Options - On account of abolition of dividend distribution tax (DDT), the investors in the higher tax brackets have been impacted the most because they will be taxed at their marginal tax rates instead of earlier DDT rates. At the same time, investors in the low tax bracket may tend to gain if their effective tax rate is lower compared to DDT rates.

Investors need to evaluate their tax position and decide which mutual fund option works best for meeting their investment objectives - growth or dividend option.

(2) Tax credit to non-resident investors - Prior to abolition to DDT, the non-resident investors were not in a position to claim tax credit of DDT in their home countries as the DDT was not paid by them. With the abolition of DDT and adoption of classical system of taxation, the credit of taxes paid on dividend income by non-resident investors in India will now be available, subject to local laws in their country of residence.

(3) TDS rate on capital gains for non-resident investors (excluding FPIs) - Prior to Finance Act, 2020, non-resident investors (excluding FPIs) were subject to TDS at the ‘rates in force’ on capital gains in accordance to provisions of section 195 of the Act. This provided a leeway to the Mutual Funds to withhold tax as per the rates provided under the Double Taxation Avoidance Agreement (DTAA), subject to certain conditions.

However, on account of the Finance Act, 2020, the Mutual Fund is now required to withhold tax as per section 196A of the Act which provides for a TDS rate of 20% (plus applicable surcharge and cess) on any income earned from Mutual Fund. This has resulted in the following issues –

(a) TDS at the rate of 20% (plus applicable surcharge and cess) on capital gains notwithstanding that such capital gains may be taxable at a rate lower than 20% (especially in case of equity schemes where the tax rates under the Act are 10% or 15%)

(b) No DTAA benefit to non-resident investors (excluding FPIs) at the time of tax withholding

(c) Investors will be forced to claim income-tax refund by filing their India tax returns resulting in temporary cash flow issues

The intention of the lawmakers was to introduce tax withholding on dividend income by abolishing DDT. However, this has resulted in consequential change in the way capital gains are subject to tax withholding. A formal clarification by way of a notification from the CBDT stating that section 196A of the Act is not applicable to capital gains from Mutual Fund investments would be a welcome move.

[Note: Notification has been issued by CBDT w.r.t. section 194K of the Act to carve out capital gains and same has been incorporated in the law].

(4) Surcharge rate on dividend from mutual funds- Similar to capital gains u/s 111A and 112A of the Act, the surcharge rate on ‘dividend income’ has been capped at 15% in the hands of non-corporate tax payers. Accordingly, higher surcharge rate of 25% / 37% shall not be applicable. However, this benefit may not apply to distribution income [commonly known as dividend income] from Mutual Funds since such distributions are not technically "dividends" under the Act.

One may refer section 2(22), section 8, section 115-O and section 115R of the Act to understand the aforesaid difference between ‘dividend income’ and ‘distribution income’.

(5) DTAA benefit on dividend from mutual funds - Non-resident investors earning dividend income from mutual funds may not be able to claim lower tax rates provided under the DTAA Article on "Dividend” as the scope of this article is limited to corporate dividends only. In the absence of any specific Article, the dividend income from mutual funds should get covered under the Article on "Other income” which in most cases does not provide any tax benefits.

The author can be reached at bhs6992@gmail.com

Disclaimer: This article is meant purely for general education purpose only and is not intended to be advise or a legal opinion on any particular matter. I accept no responsibility for any errors it may contain, whether caused by negligence or otherwise. Readers are advised to rely on their own analysis and consult their own professional advisors.