How your fund income & dividend are taxed

Investors consider various riskreturn measures while investing in stocks, bonds, mutual funds and other financial instruments. One of the important factors that influences investment decisions is the manner in which the income or profits from investments are taxed.

Different financial instruments have varied tax structures and, therefore, it is important to consider the post-tax return for comparing performance across different investment avenues. Let us consider the tax treatment of mutual funds.

Mutual funds are subject to two types of taxes—dividend distribution tax and capital gains tax. While the dividend/income schemes are subject to dividend/income distribution tax, all schemes (dividend/growth/bonus) are subject to capital gains tax (applicable on gain/profit made on sale of fund units).

In this part, we will consider the dividend distribution tax in detail and the applicable tax rates. Dividend/income distribution tax The income earned by a mutual fund is exempt from tax. However, the income distributed by a mutual fund to its unit holders is subject to dividend/income distribution tax. The tax is levied on the fund, not the unit holders, and the income/dividend received by unit holders is tax-free.

However, the tax is paid by the fund from its resources and it impacts the unit holders indirectly. The effect is reflected in the scheme’s NAV, which gets reduced by the amount of tax paid. In the long term, the income distribution tax substantially affects the value of investments.

Let us look at the dividend distribution tax rates on different fund categories: Equity funds: The dividends distributed by equity or equity-oriented funds are exempt from dividend distribution tax. Equity oriented funds are those which invest more than 65% of their corpus in equity shares of domestic companies. Debt funds: These funds invest in mediumto long-term debt securities, such as government bonds, corporate bonds/debentures, etc.

The income distributed by debt funds to individuals and HUF is subject to income distribution tax of 12.5%. The fund is also liable to pay the applicable surcharge and cess on the amount of tax. Liquid or money market funds: These types of funds invest in short-term debt securities (which have a duration of less than one year), such as commercial paper, certificates of deposit, call money, etc.

The income distributed by such funds is subject to the income distribution tax of 25%. The fund is also liable to pay applicable surcharge and cess on the tax amount.