Mutual Funds Taxation and Regulations PDF

UNIT -6 : Taxation and Regulations Taxation in case of Mutual Funds must be understood, primarily, from Capital Gains, Securities Transaction Tax (STT) and Dividends point of view. Tax rules differ for equity and debt schemes and also for Individuals, NRIs, OCBs and corporates. Investors also get...

UNIT -6 : Taxation and Regulations Taxation in case of Mutual Funds must be understood, primarily, from Capital Gains, Securities Transaction Tax (STT) and Dividends point of view. Tax rules differ for equity and debt schemes and also for Individuals, NRIs, OCBs and corporates. Investors also get benefit under section 80C of the Income Tax Act if they invest in a special type of equity scheme, namely, Equity Linked Savings Scheme. 6.1 Capital Gains Taxation 1. Equity mutual funds Long Term Capital Gains (More than 12 months 0% holding period) Short Term Capital Gains 15% basic tax plus surcharge plus other cess (Less than or equal to 12 months holding period) that may be applicable To understand Capital Gains Taxation, definitions of equity and debt schemes must b e understood; similarly difference between Long Term and Short Term must also be understood. 1. Equity schemes As per SEBI Regulations, any scheme which has minimum 65% of its average weekly net assets invested in Indian equities, is an equity scheme. If the mutual fund units of an equity scheme are sold / redeemed / repurchased after 12 months, the profit is exempt. However if units are sold before 12 months it results in short term capital gain. The investor has to pay 15% as short term capital gains tax. While exiting the scheme, the investor will have to bear a Securities Transaction Tax (STT) @ 0.001% of the value of selling price. Investors in all other schemes have to pay capital gains tax, either short term or long term. In case a scheme invests 100% in foreign equities, then such a scheme is not considered to be an equity scheme from taxation angle and the investor has to pay tax even on the long term capital gains made from such a scheme. 2. Mutual fund schemes (other than equity) i.e. debt funds, liquid schemes, gold ETF, short term bond funds etc. All other funds (other than equity) Residents – 20% with indexation benefit Long Term Capital Gains (More than 3 6 months holding period) FII – 10% without indexation benefit Short Term Capital Gains Marginal Rate of Tax (Less than or equal to 3 6 months Profit added to income holding period) 110  In case such units are sold within 36 months, the gain is treated as short term capital gains. The same is added to the income of the tax payer and is taxed as per the applicable tax slab including applicable surcharge and cess depending on the status of the tax payer. This is known as taxation at the marginal rate. Long term capital gains arise when the units are sold beyond 36 months. Here the taxation rules are o For resident investor - 20% (plus surcharge and cess as applicable) (with indexation) o For FII - 10% basic tax (plus surcharge and cess as applicable) on long term capital gains (without indexation) 6.2 Indexation Benefit Indexation is a procedure by which the investor can get benefit from the fact that inflation has eroded his returns. Indexation works on the simple concept that if an investor buys a unit @ Rs. 10 and sells it @ Rs. 30 after 5 years, then his profit of Rs. 20 per unit needs to be adjusted for the inflation increase during the same time period. This is because inflation reduces purchasing power. What Rs. 100 could have bought when he bought the unit @ Rs.10, would now have increased in price due to inflation. Thus he can now buy less for the same Rs. 100. If during the same time, inflation has increased by 12%, then the adjusted cost of the unit purchased (at today‘s price) would be Rs. 10 * (1 + 12%) = Rs. 11.2. So his profit would not be Rs. 20, but Rs. 30 – Rs. 11.2 = Rs. 18.8. The cost inflation index is notified by the Central Government (form 1981 up to 2015-16). The same is used by the tax payer for calculating long term capital gains. Example An investor purchased mutual fund units in January 2006 of Rs.10,000. The same was sold in the previous year for Rs.25,000. Long term capital gains applicable is as follows:  FII - Without availing indexation benefit - Pay 10% on Rs,15,000 (Rs.25000 – Rs.10,000) = Rs.1,500  Resident - Calculate indexed cost of acquisition (Rs.10,000 X 1081/ 497) = Rs.21,751, Capital gains = Rs.25,000 – Rs.21,751 = Rs.3,249, Tax@20% on Rs.3249 = Rs.650 6.3 Dividend Distribution Tax The dividend declared by mutual funds in respect of the various schemes is exempt from tax in the hands of investors. In case of debt mutual funds, the AMCs are required to pay Dividend Distribution Tax (DDT) from the distributable income. This ensures ease in tax collection. However, in case of equity funds no DDT is payable. The rates for DDT are as follows:  For individuals and HUF – 25% (plus surcharge and other cess as applicable)  For others – 30% (plus surcharge and other cess as applicable)  On dividend distributed to a non-resident or to a foreign company by an Infrastructure Debt Fund – 5% (plus surcharge and other cess as applicable) 111 6.4 Why Fmps Are Popular? A fixed maturity plan is a close ended debt fund for a specified period. The maturity of the papers invested in is matched with the duration of the plan. Consider a case where Investor A invests Rs.100,000 in a bank fixed deposit @9% for 3 years and Investor B invests Rs.100,000 in a 3 year FMP. The indicative yield of the FMP is assumed also to be at 9%. We shall analyze the tax benefit of investing in an FMP. For Investor A, the interest income per annum is 100,000 X 9% = Rs.9,000. Each year the investor would have to pay tax of Rs.2,700 (30%, assuming he is taxed at the maximum marginal rate). Total tax payable in 3 years is Rs.8,100. For Investor B, since the investment is over 36 months, it would qualify as long term capital gains. When the investor entered the fund, the cost inflation index was at 939 and when he exited at maturity the cost inflation index had risen to 1081. Thus the new indexed cost of acquisition will become Rs.100,000 X 1081/939 = Rs.115,122 Now the profit will be equal to 115,122 – 100,000 = Rs.15,122 Since we have taken the benefit of indexation, the applicable tax rate will be 20%, (surcharge / cess excluded for calculation) So the tax payable will be equal to 15,122 * 20% = Rs.3,024. The point to be observed here is that FMP is giving a higher return (post tax) as compared to a bank FD. This is true only if the investor is in the 30% tax bracket. However Bank fixed deposit offer premature withdrawal facility; hence they offer better liquidity as compared to FMP. Under section 10(23D) of the Income tax Act, 1961, income earned by a Mutual Fund registered with SEBI is exempt from income tax. 6.5 Overview Regulations ensure that schemes do not invest beyond a certain percent of their NAVs in a single security. Some of the guidelines regarding these are given below:  No scheme can invest more than 10% of its NAV in rated debt instruments of a single issuer wherein the limit is reduced to 10% of NAV which may be extended to 12% of NAV with the prior approval of the Board of Trustees and the Board of Asset Management C ompany.2  No scheme can invest more than 10% of its NAV in unrated paper of a single issuer and total investment by any scheme in unrated papers cannot exceed 25% of the NAV.  No mutual fund scheme shall invest more than 30% in money market instruments of an issuer: Provided that such limit shall not be applicable for investments in Government securities, treasury bills and collateralized borrowing and lending obligations.  No fund, under all its schemes can hold more than 10% of company‘s paid up capital carrying voting rights.  No scheme can invest more than 10% of its NAV in equity shares or equity related instruments of any company of a single company. Provided that, the limit of 10% shall not be applicable for investments in case of index fund or sector or industry specific scheme. 2 SEBI/HO/IMD/DF2/CIR/P/2016/35 112  If a scheme invests in another scheme of the same or different AMC, no fees will be charged. Aggregate inter scheme investment cannot exceed 5% of net asset value of the mutual fund.  No scheme can invest in unlisted securities of its sponsor or its group entities.  Schemes can invest in unlisted securities issued by entities other than the sponsor or sponsor‘s group. Open ended schemes can invest maximum of 5% of net assets in such securities whereas close ended schemes can invest upto 10% of net assets in such securities.  Schemes cannot invest in listed entities belonging to the sponsor group beyond 25% of its net assets.  Total exposure of debt schemes of mutual funds in a particular sector (excluding investments in Bank CDs, CBLO, G-Secs, T Bills, short term deposits of scheduled commercial banks and AAA rated securities issued by Public Financial Institutions and Public Sector Banks) shall not exceed 25% of the net assets of the scheme. An additional exposure to financial services sector not exceeding 5% of the net assets of the scheme shall be allowed only by way of increase in exposure to Housing Finance Companies (HFCs) for HFCs rated AA and above and registered with National Housing Bank (NHB).  Total exposure of debt schemes of mutual funds in a group (excluding investments in securities issued by Public Sector) shall not exceed 20% of the net assets of the scheme. Such investment limit may be extended to 25% of the net assets of the scheme wit h the prior 3 approval of the Board of Trustees. There are many other mutual fund regulations which are beyond the purview of this module. Candidates are requested to refer to AMFI-Mutual Fund (Advisors) Module for more information. 6.6 What is the name of Industry Association for the Mutual Fund Industry? AMFI (Association of Mutual Funds in India) is the industry association for the mutual fund industry in India which was incorporated in the year 1995. 6.7 What are the Objectives of AMFI? The Principal objectives of AMFI are to: 1) Promote the interests of the mutual funds and unit holders and interact with regulators - SEBI/RBI/Govt./Regulators. 2) To set and maintain ethical, commercial and professional standards in the industry and to recommend and promote best business practices and code of conduct to be followed by members and others engaged in the activities of mutual fund and asset management. 3) To increase public awareness and understanding of the concept and working of mutual funds in the country, to undertake investor awareness programmes and to disseminate information on the mutual fund industry. 4) To develop a cadre of well-trained distributors and to implement a programme of training and certification for all intermediaries and others engaged in the industry. 3 SEBI/HO/IMD/DF2/CIR/P/2016/35 February 15, 2016 113 6.8 Product Labelling in Mutual Funds – Riskometer4 The product labeling in mutual funds shall be based on the level of risk which shall be as under: Low- principal at low risk Moderately Low - principal at moderately low risk Moderate - principal at moderate risk Moderately High - principal at moderately high risk High - principal at high risk There shall be pictorial depiction of risk named ‗riskometer‘ which shall appropriately depict the level of risk in any scheme. The following depicts a scheme having moderate risk Mutual funds may ‗product label‘ their schemes on the basis of the best practice guidelines issued by Association of Mutual Funds in India (AMFI) in this regard. 6.9 Advantages of Mutual Funds Mutual Funds give investors best of both the worlds. Investor‘s money is managed by professional fund managers and the money is deployed in a diversified portfolio. Retail investors cannot buy a diversified portfolio for say Rs.5000, but if they invest in a mutual fund, they can own such a portfolio. Mutual Funds help to reap the benefit of returns by a portfolio spread across a wide spectrum of companies with small investments. Investors may not have resources at their disposal to do detailed analysis of companies. Time is a big constraint and they may not have the expertise to read and analyze balance sheets, annual reports, research reports etc. A mutual fund does this for investors as fund managers, assisted by a team of research analysts, scan this data regularly. Investors can enter / exit schemes anytime they want (at least in open ended schemes). They can invest in an SIP, where every month, a stipulated amount automatically goes out of their savings account into a scheme of their choice. Such hassle free arrangement is not always easy in case of direct investing in shares. There may be a situation where an investor holds some shares, but cannot exit the same as there are no buyers in the market. Such a problem of illiquidity generally does not exist in case of mutual funds, as the investor can redeem his units by approaching the mutual fund. As more and more AMCs come in the market, investors will continue to get newer products 4 CIR/IMD/DF/4/2015 April 30, 2015 114  and competition will ensure that costs are kept at a minimum. Initially mutual fund schemes could invest only in debt and equities. Then they were allowed to invest in derivative instruments. Gold ETFs were introduced, investing in international securities was allowed and recently real estate mutual funds where also in the process of being cleared. We may one day have commodity mutual funds or other exotic asset classes oriented funds. Thus it is in investor‘s best interest if they are aware of the nitty gritties of MFs. Investors can either invest with the objective of getting capital appreciation or regular dividends. Young investors who are having a steady regular monthly income would prefer to invest for the long term to meet various goals and thus opt for capital appreciation (growth or dividend reinvestment options), whereas retired individuals, who have with them a kitty and would need a monthly income would like to invest with the objective of getting a regular income. This can be achieved by investing in debt oriented schemes and opting for dividend payout option. Mutual funds are therefore for all kinds of investors. An investor with limited funds might be able to invest in only one or two stocks / bonds, thus increasing his / her risk. However, a mutual fund will spread its risk by investing in a number of sound stocks or bonds. A fund normally invests in companies across a wide range of industries, so the risk is diversified. Mutual Funds regularly provide investors with information on the value of their investments. Mutual Funds also provide complete portfolio disclosure of the investments made by various schemes and also the proportion invested in each asset type. Mutual Funds offer investors a wide variety to choose from. An investor can pick up a scheme depending upon his risk/ return profile. All the Mutual Funds are registered with SEBI and they function within the provisions of strict regulation designed to protect the interests of the investor. 6.10 What is a Systematic Investment Plan (SIP)? The above chart shows how the NAV of a scheme has moved in a given year. There was no way the investor could have known that in May the peak will be formed, after which the NAV will slide 115 for the rest of the year. The investor, by deciding to invest Rs.5000 regularly each month automatically got the benefit of the swings. As can be seen, he got least number of units in the months of Mar, Apr and May, whereas w hen the NAV continued its downward journey subsequently, he accumulated higher number of units. This is the benefit of disciplined investing. Many a times it is seen that in bear markets, when the NAVs are at their rock bottom, investor are gripped by panic and either stop their SIPs or worse, sell their units at a loss. Due to the in-built mechanism of SIP, investors average cost reduces as can be seen from the chart below: Averaging works both ways. Thus, when the NAV moves sharply in either direction, the impact of averaging is clearly witnessed as the change in average cost for the investor is only marginal. Here it can be seen that although the NAV has swung in a range of Rs.80 to Rs.140, the average cost for the investor has remained in the narrow range of Rs.100 to Rs.120. This is the impact of averaging. As can be seen, SIP helps in averaging cost of acquiring units; however STP can prove to be even better than SIP. There are a small section of investors like domestic staff, drivers and other employees earning low incomes and who may not have PAN cards or other documentation required for investing in mutual funds. They are advised by their employers to invest in SIPS. SEBI, in order to facilitate their investments, has withdrawn the requirement of PAN for SIPs where investments are not over Rs.50,000/- in a financial year. Such installments are called micro SIPs. 6.11 What is Systematic Transfer Plan (STP)? In SIP investor‘s money moves out of his savings account into the scheme of his choice. Let‘s say an investor has decided to invest Rs 5,000 every month, such that Rs. 1,000 gets invested on the 5th, 10th, 15th, 20th and 25th of the month. This means that the Rs.5000, which will get invested in stages till 25th will remain in the savings account of the investor for 25 days and earn interest @ 4-6%, depending on the bank. If the investor moves this amount of Rs.5000 at the beginning of the month to a Liquid Fu nd and transfers Rs.1000 on the given dates to the scheme of his choice, then not only will he get the 116 benefit of SIP, but he will earn slightly higher interest as well in the Liquid Funds as compared to a bank FD. As the money is being invested in a Liquid Fund, the risk level associated is also minimal. Add to this the fact that liquid funds do not have any e xit loads. This is known as STP. 6.12 What is Systematic Withdrawal Plan (SWP)? SWP stands for Systematic Withdrawal Plan. Here the investor invests a lump sum amount and withdraws some money regularly over a period of time. This results in a steady income for the investor while at the same time his principal also gets drawn down gradually. Say for example an investor aged 60 years receives Rs.20 lakh at retirement. If he wants to use this money over a 20 year period, he can withdraw Rs. 20,00,000/ 20 = Rs.1,00,000 per annum. This translates into Rs.8,333 per month. (The investor will also get return on his investment of Rs.20 lakh, depending on where the money has been invested by the mutual fund). In this example we have not considered the effect of compounding. If that is considered, then he will be able to either draw some more money every month, or he can get the same amount of Rs.8,333 per month for a longer period of time. The conceptual difference between SWP and MIP is that SWP is an investment style whereas MIP is a type of scheme. In SWP the investor‘s capital goes down whereas in MIP, the capital is not touched and only the interest is paid to the investor as dividend. 6.13 Choosing between dividend payout, dividend reinvestment and growth options – which one is better for the investor? Investors often get confused between the above mentioned (Dividend Payout, Dividend Reinvestment and Growth Options) three options which he has to choose while investing in mutual fund‘s units. These options have to be selected by the investor at the time of purchasing the units and many a times investors feel that the dividend reinvestment option is better than growth as they get more number of units. Let‘s understand the three options : 6.13.1 Growth Option Growth option is for those investors who are looking for capital appreciation. Say an investor aged 25 invests Rs.1 lakh in an equity scheme. He would not be requiring a regular income from his investment as his salary can be used for meeting his monthly expenses. He would instead want his money to grow and this can happen only if he remains invested for a long period of time. Such an investor should go for Growth option. The NAV will fluctuate as the market moves. So if the scheme delivers a return of 12% after 1 year, his money would have grown by Rs.12,000. Assuming that he had invested at a NAV of Rs.100, then after 1 year the NAV would have grown to Rs.112. Notice here that neither is any money coming out of the scheme, nor is the investor getting more units. His units will remain at 1,000 (1,00,000/ 100) which he bought when he invested Rs.1 lakh @ Rs. 100/ unit. 6.13.2 Dividend Payout Option In case an investor chooses a Dividend Payout option, then after 1 year he would Receive Rs. 12 as dividend. This results in a cash outflow from the scheme. The impact of this would be that the NAV would fall by Rs.12 (to Rs. 100 after a year. In the growth option the NAV became Rs. 112). Here he will not get any more number of units (they remain at 1,000), but will receive Rs.12,000 117 as dividend (Rs.12 per unit * 1,000 units). Dividend Payout will not give him the benefit of compounding as Rs.12,000 would be taken o ut of the scheme and will not continue to grow like money which is still invested in the scheme. 6.13.3 Dividend Reinvestment Option In case of Dividend Reinvestment option, the investor chooses to reinvest the dividend in the scheme. So the Rs.12, which he receives as dividend gets invested into the scheme again @ Rs.100. This is because after payment of dividend, the NAV would fall to Rs.100. Thus the investor gets Rs.12,000/ Rs. 100 = 120 additional units. Notice here that although the investor has got 120 units more, the NAV has come down to Rs.100. Hence the return in case of all the three options would be same. For Growth Option, the investor will have 100 units @ 112, which equals to Rs.1,12,000 while for Dividend Reinvested Option the investor will have 1120 units @ Rs. 100 which again amounts to Rs. 1,12,000. Thus it can be seen that there is no difference in either Growth or Dividend Reinvestment Plan. It must be noted that for equity schemes there is no Dividend Distribution Tax, however for debt schemes, investor will not get Rs.12 as dividend, but less due to Dividend Distribution Tax. In case of Dividend Reinvestment Option, he will get slightly lesser number of units and not exactly 120 to the extent of Dividend Distribution Tax. In case of Dividend Payout option the investor will lose out on the power of compounding from the second year onwards. Concept Clarifier – Power of Compounding Compound Interest refers to interest earned on interest. The formula for Compound Interest is: A = P *( 1 + r) t Where, A = Amount P = Principal invested r = rate of interest per annum t= Number of Years As can be seen, the three variables that affect the final Amount are Principal, rate of interest and time for which money is invested. It is time which acts as the biggest determinant as it pulls up the value in an exponential manner. Hence it is important to invest for the long term to get the benefit of compounding. 118 POINTS TO REMEMBERS Taxation in case of Mutual Funds must be understood, primarily, from Capital Gains, Securities Transaction Tax (STT) and Dividends point of view. Tax rules differ for equity and debt schemes and also for Individuals, NRIs, OCBs and corporates. Investors also get benefit under section 80C of the Income Tax Act if they invest in a special type of equity scheme, namely, Equity Linked Savings Scheme. Capital gains tax must be paid on all mutual fund schemes except equity schemes. Indexation is a procedure by which the investor can get benefit from the fact that inflation has eroded his returns. The dividend declared by mutual funds in respect of the various schemes is exempt from tax in the hands of investors. In case of debt mutual funds, the AMCs are required to pay Dividend Distribution Tax (DDT) from the distributable income. Regulations ensure that schemes do not invest beyond a certain percent of their NAVs in a single security. AMFI (Association of Mutual Funds in India) is the industry association for the mutual fund industry in India which was incorporated in the year 1995. The product labeling in mutual funds shall be based on the level of risk which is represented pictorially. Mutual funds have various advantages like professional management, expert fund managers, investment through small amounts, etc. Systematic investment plans helps the investor invest a certain sum of money every month. This helps in regular saving as well as evens out the market differences over the period of investment SEBI, in order to facilitate investments in SIPS by small investors, has withdrawn the requirement of PAN for SIPs where investments are not over Rs.50,000/- in a financial year. Such instalments are called micro SIPs. Transfer of funds from one mutual fund scheme to another at regular intervals is referred to as systematic transfer plan. In a Systematic Withdrawal Plan the investor invests a lump sum amount and withdraws some money regularly over a period of time. Investors must understand clearly the various options like dividend payout, dividend reinvestment and growth options in mutual fund schemes and choose the one that helps them achieve their goal. 119