HOW TO CALCULATE SHORT TERM CAPITAL GAINS TAX ON DEBT FUNDS?

Last Updated: 29 Mar 2022

What is it that we need to know when it comes to capital gains calculation on debt funds? There are 3 questions you need to answer to begin with.

1. How to decide if it is a debt fund? The Income Tax Act classifies funds as equity funds and non-equity funds and debt funds fall under non-equity funds. If the portfolio mix is more than 65% in favour of equities, it is an equity fund. Otherwise it will be classified as a debt fund and taxed accordingly.
2. If it is a debt fund, what are the sources of flows? Firstly, there is the dividend that is paid out by the dividend plans of debt funds. This is useful for those who need regular income. Capital gains arises when you buy a debt fund at a certain price and sell at a higher price. For example, bought X Debt Fund at NAV of Rs.85 and sold at Rs.94.
3. For debt funds, if the fund is held for more than 36 months it becomes long term capital gains and is taxed accordingly. However, if the holding is less than 36 months, then the gains are classified as short term capital gains. The tax treatment is different as we will see later. This is the waterfall to remember.

UNDERSTANDING THE CONCEPT OF CAPITAL GAINS IN MUTUAL FUNDS

How are capital gains taxed on mutual funds? Capital gains are profits generated by selling or redeeming mutual funds. For example, if you buy a mutual fund unit at Rs.100 and sell at Rs.105, then the Rs.5 difference will be treated as capital gains. In the same way, if you buy a fund unit at Rs.100 and sell at Rs.96, then the difference of Rs.4 will be treated as a capital loss.

As stated earlier, the taxation of capital gains will depend on 2 factors. Firstly, it is based on whether the fund is an equity fund or debt. The definition of equity fund is if at least 65% of the AUM is held in equities. Otherwise it is classified as a debt (non-equity) fund. The second consideration is whether the capital gains are long term or short term. Both equity and debt funds are taxed on capital gains at different rates. For equity funds, the cut-off is 12 months for long term, while for debt funds it is 36 months cut-off.

DEMARCATION OF EQUITY FUNDS AND DEBT FUNDS FOR INCOME TAX PURPOSES

Demarcation becomes critical because there are equity funds with a debt component and debt funds with an equity component. Then there are balanced funds which deliberately mix equity and debt. How is the demarcation decided? Tax status of mutual fund holdings is based on whether a fund is classified as an equity fund or as a debt fund. If 65% or more of the AUM is invested in equities then it is classified as an equity fund, otherwise it is a debt fund.

SEBI defines what time period is to be considered and at what points of time such mix has to be maintained. As per this definition, equity diversified funds, sector funds, thematic funds, arbitrage funds and even aggressive balanced funds are classified as equity funds for tax purposes. On the other hand, bond funds, liquid funds, credit risk funds, MIPs, FMPs, ultra-short term funds, G-Sec funds etc are all classified as debt (non-equity funds) for taxation purposes.

FIRST UNDERSTAND HOW DIVIDENDS ON DEBT FUNDS ARE TAXED

Debt funds can also pay dividends only out of income and not out of capital. So, dividends can be paid out of interest earned by the fund on the bonds or out of capital gains generated by trading in these bonds. Even in debt funds there is nothing like assured dividends. Investors often get misled by names like Monthly Income Plan (MIPs) and FMPs, but even these funds can only indicate approximate dividend and that is not an assured dividend.

When it comes to taxation of dividends on debt funds, there are two scenarios viz. prior to Feb-2020 and after Feb-2020. In the situation prior to Feb-2020, debt fund dividends were tax free in the hands of the investor. However, prior to Feb-2020 dividends on debt funds attracted higher rates of dividend distribution tax (DDT). When debt fund declares dividend, DDT of 29.12% (25% tax + 12% surcharge + 4% cess) was cut and net amount was paid out.

Let us now come to the post Feb-2020 scenario. In the Union Budget announced by Nirmala Sitharaman, in Feb-2020, the idea of DDT was totally scrapped. Instead, the dividends were made taxable in the hands of the investor at the peak incremental rates applicable to them. Hence those in the 30% income tax bracket will pay tax on debt fund dividends at 30% and so on.

Dividends have been fairly tax inefficient for debt funds which is why many investors gravitate towards systematic withdrawal plans (SWP). This is a more scientific method of planning your taxes using debt funds. In a SWP, the entire corpus of the investors is invested in a debt fund and gradually and systematically withdrawn over a number of years. This withdrawal has a principal component and a capital gain component which makes it more tax friendly for investors.

CAPITAL GAINS (LTCG AND STCG) ON DEBT FUNDS

In case of debt funds (less than 65% in equities), the definition of long term is a holding period of more than 36 months. Any debt fund held for less than 3 years will be classified as short term capital gains for the purpose of taxation. Being classified as STCG or LTCG can make a bid difference to the taxation of debt funds. That is because not only are LTCG taxed at a lower rate but LTCG on debt funds also getting the added benefit of indexation, which is not available for short term capital gains on debt funds.

In case of debt funds, the STCG (less than 36 months) will be taxed at peak incremental income tax rate applicable (10% or 20% or 30%). Since it will be added to your regular income, your effective rate of tax at the highest bracket will be 31.2% (30% tax + 4% cess). LTCG on debt funds will continue to attract a tax of 23.296% (20% tax + 12% surcharge + 4% cess). However, in this case there will be the benefit of cost inflation indexation available. The benefit is that the purchase cost can be indexed to the sale date based on the Income Tax Department’s Cost Inflation Index. This can substantially reduce the tax incidence in case of long term capital gains.

While indexation benefit is not available to short term capital gains, let us quickly understand how it works in case of long term capital gains in debt funds. Here you can go one step further and also get the benefit of double indexation. How does that work. If you purchased a debt fund on March 29th 2015 and sold it on April 03rd 2018. Actually, you have held it for a period of 3 years and 5 days. However, since this trade straddles 4 financial years (2014-15 to 2018-19), you get the benefit of one more year of indexation. This is a popular method among HNIs to reduce tax burden.

HOW DO YOU TREAT CAPITAL LOSSES ON DEBT FUNDS?

The profit part is simple. How do you handle if you have short term or long term losses on debt funds? Losses can be adjusted against profits and they can also be carried forward. Here are some key points to remember about capital losses on debt funds.

• Short term losses on debt funds can be set of against STCG and LTCG. However, long term losses can only be set off against LTCG. You pay tax on the net capital gains after adjusting for these losses.
• What if your losses are more than your gains? In this case you can also carry forward unadjusted losses for a period of 8 assessment years after the current fiscal year. This is an important aspect to understand to reduce your capital gains taxes substantially.