Taxation and Tax saving

Tax in the hands of funds

Any income of a mutual fund registered under the SEBI Act, 1992 is exempt from income tax under Section 10 (23D) of the Income Tax Act, 1961. Thus, any income generated by the fund through investments, either in the form of capital gains (short term or long term), dividends or interest is exempt from income tax.

In the hands of investors, the income is not taxed, however if the scheme declares dividends, it pays dividend distribution tax (DDT) which is deducted from the surplus generated by the scheme and paid to the government.

An investor can make money in two ways, either in the form of dividends received or in form of capital gains. The capital gains can be further divided in two categories – long term or short term – depending on the holding period of the investment. The dividend may be subject to distribution tax, which is deducted by the fund before the distribution of dividend to investors.A ready reckoner on the tax rates applicable is given as under:

Income tax ready reckoner
Nature of income Type of fund
Equity fund Income fund Liquid fund
Long term capital gains Nil 10% with surcharge and cess without the benefit of indexation or 20% with surcharge and cess with the benefit of indexation
Short term capital gains 15% plus surcharge and cess Clubbed with the annual income and taxed at the marginal rate of tax applicable to the assessee.
Dividend distribution tax Nil 12.5% plus surcharge and cess for individuals and 20% plus surcharge and cess for non-individuals 25% plus surcharge and cess on the distributed dividend

(The above table has been prepared keeping the provisions of the Income Tax Act, 1961 as applicable before the Union Budget 2011 and is subject to change from time to time as per changes in the Act.)

  • Upsetting the corporates investing in mutual funds, for liquid mutual funds, the Dividend Distribution Tax (DDT) has been increased from 25% to 30%. For debt funds- other than Liquids- it (DDT) has been increased from 20% to 30%, thereby attempting to remove the advantage which the corporates enjoyed by investing in liquid and debt mutual funds (for a period not exceeding 1 year) over Fixed Deposits.
  • Mutual funds will not find it easy to attract short term surplus funds from corporates who park their surplus funds in liquid and debt mutual funds. However corporates who wish to park their long term funds (for a period of over 1 year) can still look at debt mutual funds by participating in the growth option as it still remains tax efficient (as it will continue to provide indexation benefit on long term capital gains).

Tax saving schemes under Section 80C of the Income Tax Act, 1961

Section 80C of the Income Tax Act, 1961 allows an assessee deduction in respect of certain investments, the limit for the said deduction is 1,00,000 (one lac) per year per assessee. From FY 10-11, a sub-section 80CCF has also been introduced where one can invest up to 20,000/-(twenty thousand only) in Long Term Infrastructure Bonds issued by some specified institutions/ entities and avail additional tax benefit.

A mutual fund investor can avail of the deduction through investment in notified mutual fund schemes, known as ELSS (Equity Linked Saving Schemes). This helps them not only in availing tax benefits under section 80C, but also gives them the benefit of diversification in equity for a long time period. Dividends are tax free in the hands of the investors and long term capital gains are also tax free.

What are Tax saving options available ?

Tax-saving options under Section 80C

Other deductions
In 2008, Senior Citizens Saving Scheme 2004 and the Post Office Five Year Term Deposit Account have also been brought under the perview of this Section and additional deduction of 15,000 allowed under Section 80 D to individuals paying medical insurance premium for his/her parent(s).

What are Equity Linked Saving Schemes?
Equity linked savings schemes (ELSS) are mutual funds that help you gain the twin advantage of earning equity-linked returns with the additional benefit of saving tax. ELSS have a lock-in period of 3 years, which encourages long term investing among investors and gives ample time for the fund manager to manage a portfolio of stocks that can outperform over a period of time.

Why is the Equity Linked Savings Scheme a winner ?
Over a longer horizon, it has ben witnessed that equities outperform most other asset classes in terms of returns.

Advantages of ELSS
  • Investments in equity delivers higher returns over a longer period, surpassing returns from other tax saving instruments
  • A lock-in of 3 years ensures you stay invested for a longer period, thus allowing your money to grow over a period of time.
  • ELSS will endeavour to provide higher returns with tax-efficiency
  • One has the option of investing small amounts of 500 each month in ELSS through Systematic Investment Plans (SIPs)

Comparison of risk and returns vis-a-vis other tax saving instruments

Past performance may or may not be sustained in future. All rates of return except ICICIPru Tax Plan are from RBI, Handbook of Statistics on Indian Economy, 1999, 00 and 04, SBI and Some of these instruments are not liquid, so the value is only indicative computed using the return as on 19/8/1999 on a compounded annual growth rate basis. ICICI Prudential Mutual Fund Tax Plan returns are CAGR and are based on NAV on 19/8/99, which was 10 and NAV on Nov 28, 2008 (29-Nov-08 & 30-Nov-08 were non business days), which was 50.81 No loads are considered in the computation. Past performance may or may not be sustained in the future. PPF interest rates were modified to 11% on 15 Jan 2000, 9.50% on 1 March 2001, 9% on 1 March 2002 and 8% on 1 March 2003.