Elss Taxation - How Elss Funds Are Taxed?

Last Updated: 14 Jun 2024

One of the biggest attractions of an equity linked savings scheme (ELSS) is the tax benefit of the special exemption that comes with the ELSS Fund. Otherwise the ELSS fund is just like any other diversified equity fund since the chunk of the portfolio allocation is into equities.

What Exactly Is This Exemption Available On Elss Funds

Under the Income Tax Act, various exemptions are offered to encourage people to save and invest money prudently as a long term social security for themselves and their family. For example, if you look at the list of Section 80C eligible investments, they include:

• Public Provident Fund
• Employees Provident Fund
• LIC premium
• Equity Linked Saving Scheme (ELSS)
• Principal payment towards home loan
• Sukanya Samriddhi yojana (SSY)
• National saving certificate (NSC)
• Senior citizen savings scheme (SCSS)
• Unit Linked Insurance Plans (ULIP)
• Tax saving FD for 5 years
• Infrastructure bonds etc.

Remember that ELSS is one of the investment outlays eligible for Section 80C benefits and the total benefit of Section 80C is available at Rs.150,000 for all these investment allocations put together. There have been persistent demands in each budget to enhance this limit but the government has not exactly relented to that demand. For now ELSS exemption is carved out of Section 80C, and competes with all the above products.

Do Elss Funds Offer Any Benefit On Dividends And Capital Gains Tax?

There is no difference on dividend and capital gains tax between ELSS and regular equity funds. Let us look at dividends first. In the case of ELSS Funds and equity funds, if you opt for dividend option, then the dividend is fully taxable in the hands of the investor at the peak incremental rate applicable. It could be 20% or 30% as the case may be and the surcharge and cess as applicable will also be levied.

In the case of equity funds, short term capital gains arise if held below 1 year. In that case, the gains will be taxed at a concessional rate (compared to other assets) of 15% plus cess and surcharge. Short term capital gains are not applicable to ELSS funds as they have a minimum lock in period of 3 years. Again in the case of long term returns, the tax treatment for equity funds and ELSS funds is the same. LTCG is taxed at 10% flat above Rs.1 lakh exemption on capital gains annually. Flat tax means; no indexation benefit is available.

The big difference between equity fund and ELSS funds lies in the applicability of Section 80C of the Income Tax Act on investment. ELSS also offers exemption under Section 80C of the Income Tax Act for the amount invested in ELSS during the year. Section 80C of the Income Tax Act offers exemption up to an outer limit of Rs.150,000 per year and the list of investments have been indicated in the first section. Your tax benefit is equivalent to the applicable tax rate on the exempt amount. No such benefit exists for normal equity funds.

How Does The Section 80c Tax Exemption Enhance Elss Yields?

To understand the tax implication of the ELSS Funds, let us compare two investors who invest same amount of money in an equity fund and ELSS fund respectively.

Investor A (Equity Fund)	Amount	Investor B ( ELSS Fund)	Amount
Investment amount	100,000	Investment amount	100,000
Value at the end of 3 years	175,000	Value at the end of 3 years	175,000
Profit in INR	75,000	Profit in INR	75,000
Total Returns over 3 years	75.00%	Total Returns over 3 years	75.00%
CAGR Returns	20.60%	CAGR Returns	20.60%
Effective Returns after considering Section 80C benefits
Exemption u/s 80C	–	Exemption u/s 80C	30,000
Effective Investment in T1	100,000	Effective Investment in T1	70,000
Effective CAGR Returns	20.60%	Effective CAGR Returns	35.80%
Note: For simplicity, we ignore the impact of surcharge and cess on tax

How did this big difference come? How did the same fund with tax benefit give nearly 75% higher returns? In reality, the tax exemption reduces your effective investment in the year you put money in ELSS.

For example, if you invest Rs.100 and get back Rs.20 as tax exemption, then you are effectively investing only Rs.80. On that lower base, your actual ROI gets substantially magnified. That is the power of an ELSS as the effective yields are after considering the tax shields.

In a way, you can say that ELSS combines the best of equity returns and tax savings giving a powerful post-tax performance.

Can You Recap How Dividends And Capital Gains Taxed In Elss Schemes?

There is no difference between taxation of an equity fund and ELSS Fund with respect to taxation of dividends and capital gains.

• In the case of ELSS funds, any dividend is treated as other income and taxed at peak incremental rate. Currently, since dividends are fully taxable in the hands of the recipient, there is no dividend distribution tax or DDT deducted by the fund.
• Short term capital gains tax is not applicable in case of ELSS Funds as it is locked in for a period of 3 years. However, in case of equity funds, short term capital gains are taxed at the rate of 15% plus the applicable cess and surcharge.
• In the case of ELSS, all capital gains will be long term capital gains. In the case of equity funds, gains after 1 year will be LTCG. These LTCG gains will be taxed at 10% flat beyond an exempt capital gain on equities limit of Rs.1 lakh. There will be no indexation benefit.

How Elss Benefits Work Out Under The Two Systems Of Taxation?

ELSS funds are the mutual fund class eligible for tax deductions under Section 80C of the Income Tax Act. The tax benefit makes all the difference. However, in Union Budget 2020, there was a slight modification in the tax slabbing model.

Under the new income tax regime, assesses can opt for lower tax slabs by forfeiting various exemptions and deductions offered including under Section 80C. In case, you have investments in ELSS, then which model should you really opt for; The old exemption model or the new flat tax model?

Under the old tax structure, investors can invest up to Rs.150,000 in ELSS funds each financial year and avail tax savings of nearly Rs.46,800 (assuming tax @30% plus 4% Health & education cess). Here are 2 basic rules that will help you make a choice.

1. If you belong to the lower tax slab of up to Rs.9 lakh, you can opt for the old tax exemption scheme and invest in ELSS funds as your income tax liability will be lower.
2. However, if your income is above Rs.9 lakh, the new flat tax scheme could work to your benefit as your tax liability will be lower in that case.

Here we are assuming that ELSS is the only Section 80C exemption you are claiming. If that is not the case, then your calculations could change further.