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July 7, 2000

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Tax implications of mutual funds

Sameer Doctor

ELSS or equity-linked-savings schemes are another class of equity investments with tax saving benefits. The only catch being that these schemes have a minimum lock-in period of three years. A sharp contrast to other open-ended schemes that offer a high degree of liquidity.

Section 88 of the Income Tax Act offers a 20 per cent tax rebate against investment up to Rs 60,000 in specified investments such as PPF, NSC and LIC. An additional Rs 10,000 in infrastructure bonds is also allowed. ELSS has a limit of Rs 10,000 which is part of the primary Rs 60,000.

Assume you have a tax liability of Rs 15,000 for the year. You invest Rs 10,000 under an ELSS scheme. This leaves you with a liability of Rs 13,000. Being a good investment, you invest Rs 60,000 in PPF. However, you get the benefit against only Rs 50,000 (Rs 10,000 tax saved) upto the total limit of Rs 60,000. If you also buy infrastructure bonds worth Rs 10,000, you now have to pay an income tax of only Rs 1.000, while building up capital for your future.

An ELSS scheme offers good potential for growth, since, of the original Rs 10,000 invested, Rs 2,000 is tax saved, and so effectively, your additional investment is only Rs 8,000. Well-managed ELSS schemes should consistently deliver about 20 per cent to 25 per cent tax-free returns per annum.

All dividends from mutual funds investing over 50 per cent in equity are tax-free at least for the next two years. If the equity component is below 50 per cent, a dividend tax of 22 per cent is to be paid by the fund, and the dividend is tax-free in the hands of the investor. Investments up to Rs 10,000 per annum in an ELSS offer an IT rebate of 20 per cent of invested amount in addition to the other tax benefits mentioned above.

On sale of units held over a year, long-term capital gains tax is applied, which is either 10 per cent of the total gain or 20 per cent of the indexed gain (inflation adjusted).

The ideal option for an equity investment would be to choose the dividend option. In case you do not need the cash, choose the dividend re-investment option, as this would minimise the capital gain, and therefore the capital gains tax. The dividend itself is tax-free anyway.

For debt investments, it would be preferable to select the growth option, where no dividend is paid, especially if the investment is long term and you do not need the dividend for at least a year. You could sell off units equal to, say, 1 per cent of invested amount every month after one year, pay capital gains of 10 per cent (or 20 per cent indexed) and get a regular income without having to pay the 22 per cent dividend tax, saving about 12 per cent per annum of tax on these earnings. Also, your principal is intact, as every month, the appreciation in the remaining units would compensate for the monthly withdrawal of up to 1 per cent of invested amount held.

Section 54EA and EB investments offered relief from paying long term capital gains tax on your capital gains, provided the capital gain was invested in specified instruments including mutual funds, ICICI / IDBI bonds and bank deposits. Under section 54EA, the entire amount was to be invested with a lock in of three years, while one could invest half of the capital gain for seven years under section 54EB. However, this option has been phased out from the current financial year, although capital gains booked before March 31 can be invested under these sections until September 31.

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