Capital gains on transfer of mutual funds

Introduction

The tax treatment of the capital gains arising from the transfer of a unit of mutual funds depends upon the percentage of the total proceeds of the scheme invested in the equity share of the domestic company.

1. Scheme of Mutual Funds

As per Regulation 2(1)(q) of the SEBI (Mutual Funds) Regulations, 1996 ("MF Regulations"), "mutual fund" means a fund established in the form of a trust to raise monies through the sale of units to the public or a section of the public under one or more schemes for investing in securities, money market instruments, gold or gold related instruments, silver or silver related instruments, real estate assets and such other assets and instruments as may be specified by the Board from time to time.

The schemes of mutual funds are governed by Circular No. SEBI/HO/IMD/DF3/CIR/P/2017/114, dated 6-10-2017. The mutual fund schemes are broadly classified into the following:

(a) Equity Schemes: In these mutual fund schemes, 65% to 80% of total assets are invested in equity and equity-related instruments

(b) Debt Schemes: In these mutual fund schemes, the funds are invested in debt, money market instruments, corporate bonds, debt instruments, government securities (G-secs), etc.;

(c) Hybrid Schemes: In these mutual fund schemes, the funds are invested in equity, equity-related instruments, debts instruments, etc.;

(d) Solution-Oriented Schemes: These mutual fund schemes are retirement funds and children's funds;

(e) Other Schemes: These mutual fund schemes are Index Funds, Exchange-Traded Funds (ETFs) and Fund of Funds (FoFs).

As per Regulation 2(1)(jb) of the MF Regulations, "exchange-traded fund" means a mutual fund scheme that invests in securities in the same proportion as an index of securities and the units of the exchange-traded fund are mandatorily listed and traded on the exchange platform.

As per Regulation 2(1)(ma) of the MF Regulations, "fund of funds scheme" means a mutual fund scheme that invests primarily in other schemes of the same mutual fund or other mutual funds.

The mutual funds are either close-ended or open-ended schemes. "Close-ended scheme" means any scheme of a mutual fund in which the period of maturity of the scheme is specified. "Open-ended scheme" means a scheme of a mutual fund which offers units for sale without specifying any duration for redemption

2. Classification of mutual funds for capital gains

In Income-tax Act, the taxation of the capital gains from the transfer of mutual funds is classified based on the funds invested by the mutual funds out of total proceeds in equity and equity-related instruments.

2.1. Investment in equity is 90% or more

Where a Fund of Funds (FoF) invests a minimum of 90% of the total proceeds in the units of other funds, and that other fund also invests a minimum of 90% of the total proceeds in the equity shares of domestic companies listed on a recognised stock exchange, the capital gains arising to the unitholder from the transfer (including maturity or redemption) of units shall be taxable as under:

(a) The long-term capital gains shall be taxable under Section 198;

(b) The short-term capital gains shall be taxable under Section 196.

2.2. Investment in equity is 65% or more

Where a mutual fund invests 65% or more of total proceeds in the equity shares of domestic companies listed on a recognised stock exchange, the capital gains arising to the unitholder from the transfer (including maturity or redemption) of units shall be taxable as under:

(a) The long-term capital gains shall be taxable under Section 198;

(b) The short-term capital gains shall be taxable under Section 196.

2.3. Investment in equity is more than 35% but less than 65%

Where a mutual fund invests more than 35% but less than 65% of total proceeds in the equity shares of domestic companies listed on a recognised stock exchange, the capital gains arising to the unitholder from the transfer (including maturity or redemption) of units shall be taxable as under:

(a) The long-term capital gains shall be taxable under Section 197;

(b) The short-term capital gains shall be taxable as per applicable rates.

2.4. Investment in equity is 35% or less

2.4-1. Units acquired before 01-04-2023

If a mutual fund invests 35% or less of its total proceeds in equity shares of domestic companies and the units of such fund are acquired before 01-04-2023, the tax treatment for capital gains arising from the transfer of such units shall be as follows:

(a) The long-term capital gains shall be taxable under Section 197;

(b) The short-term capital gains shall be taxable as per applicable rates.

2.4-2. Units acquired on or after 01-04-2023

If the investment of a mutual fund in equity shares of domestic companies is 35% or less and the units of such fund are acquired on or after 01-04-2023, its taxability further depends on the nature of the underlying investments made by the fund.

Where the mutual fund invests more than 65% of their total proceeds in debt-based securities (such as debt instruments

(a) Capital gain from the transfer, redemption, or maturity of these funds will be treated as short-term capital gain, regardless of the holding period.

(b) The short-term capital gain will continue to be taxed under Section 76.

(c) The short-term capital gain will be taxed at normal income tax rates.

On the other hand, funds such as Gold ETFs, Gold Mutual Funds, foreign index funds, and other funds investing 65% or less of their total proceeds in debt securities shall not qualify as Specified Mutual Funds (SMFs). Accordingly, capital gains arising from the transfer, redemption, or maturity of such funds shall be taxable in accordance with the general capital gains provisions, and not under section 76.

3. Comparison of taxation of capital gains from mutual funds

3.1. Units acquired before 01-04-2023