Mutual Fund Investment in India - Capital Gains Tax Liability While Switching

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Question: We can switch our investments from equity fund to debt fund in the same fund house and normally it would not attract any exit or entry load. Will there be any long term capital gain or short term capital gains tax liability in this case? For example, assume that I have invested 100000 Indian rupees in equity fund on January 1, 2010 and on June 1, 2010 the portfolio value raises to 120000 Indian rupees approximately 20% gain within a year. If I transfer 120000 Indian rupees to a debt fund with the same fund house, what are the tax implications on me? I assume that there is nothing. Alternatively what is the tax implication in the opposite case from debt fund to equity fund?

Answer: A switch from one fund (source) to another fund (target) is actually a combination of two transactions:

  1. Redemption of units in the source; and
  2. Fresh purchase of units in the target

With that established, we can easily identify the tax repercussions

Equity Fund to Debt Fund

One: Appropriate securities transaction tax will be levied at the time of the switch on the Equity Fund investment.

If the equity fund investment is held for less than a year, we are subject to short term capital gains at 10% of the gain (as per current tax rates; may change in next budget) plus applicable surcharge.

If the equity fund investment is held for more than a year, it qualifies as long term capital gains. And because we have already paid securities transaction tax, long term capital gains on the equity asset class is waived off over the mutual fund units.

Debt Fund to Equity Fund

No securities transaction tax is payable at the time of redemption of the debt fund units.

Short term capital gains and long term capital gains have the same meanings; and are differentiated by the holding period of one year.

But the tax rates are different. STCG on a debt instrument is equivalent to interest income (gets added directly to your overall taxable income in the financial year); LTCG is currently taxed at 10% plus applicable surcharge.

And in the example you quoted:

The securities transaction tax is 0.25% on the transacted amount; which works out to 0.25%*120000, i.e., Rs.300/-.

The investment here is held for less than a year. The tax liability would be: Rs.300 (STT) + 10% of 20000 (STCG) + 10.2% of 10% of 20000 (Surcharge plus Education Cess) which is: 2504 INR.

Say, the switch was performed on 10-January-2010. Because the equity investment is held for one year, there is no incidence of long term capital gains. All that needs to be paid is the STT, which is Rs.300/- (assuming that Union Budget 2010 will not alter the STT rates).

And one more thing: STT is deducted right at the time of we redeeming the equity fund. What we receive is the amount NET of STT.

However, short term capital gains are not deducted at source (like how the Accounts Department in our Company does on our salaries). We need to show the transaction details, the actual STCG made, as a part of Income Tax Returns and pay appropriate tax.

Going back to the same example that we had taken up, when filing the IT Returns in July 2010 (for the financial year April 2009 to March 2010) , the investor will have to shell out an additional Rs.2,204/- as tax (because that STT of Rs.300/- was already deducted at the time of redemption on 01-Jul-2010).

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