Of mutual funds and tax calculations

Calculating tax is a rather difficult exercise for individuals. More so, when it comes to mutual funds. This is because there are several calculations required for this purpose before arriving at the appropriate figure.

Also, there is a need to do some segregation to remove any confusion. Here are some calculations where we use the basic tax rate on these investments excluding education cess for better understanding.

Long term capital gains (Tax-free)

A few types of long-term gains on mutual fund holdings are tax-free in nature. This is applicable for equity oriented mutual fund units, which will mean coverage of diversified equity schemes, balanced funds (65 per cent or more assets in equity), sector schemes, index funds among others. If the units in these schemes are held for a period of more than a year, then the gains will qualify for zero tax.

Consider a case where an investor has bought 1,000 units in an equity oriented fund at Rs 15 per unit on August 3, 2005. If he sells the units on March 12, 2007 then the period is more than a year so the gain is long-term capital gains. If the sale price is Rs 25 per unit then the gain of Rs 10,000 (1000 units * Rs 10 profit per unit) is tax-free.

Long term capital gains (Taxable)

Mutual fund units held by an individual that are not in equity oriented schemes but say in an income scheme or a monthly income plan, then the long term capital gains are taxable. In order to qualify for LTCG, the units have to be held for more than a year.

In this case there is a choice of rates for the individual as to whether they want to pay 20 per cent with indexation or 10 per cent without indexation.

Suppose an investor buys 1,000 units in a debt oriented fund at Rs 10 per unit in June 2002 and sells all of them in September 2004 at Rs 14.5 per unit. In such a situation the individual will have to make two calculations.

Since the holding of the units is for more than a year the nature of this is long term capital gains.  First consider the gain without the benefit of indexation. The total gain comes to Rs 4,500 (1,000 units * Rs 4.5 being the profit). The tax on this would be 10 per cent without indexation that is Rs 450.

In the second calculation, take the cost inflation index, which will raise the cost of purchase for the individual. You can come across the indexation rates from the CII charts issued by the tax department.

Here the applicable index numbers are 447 for 2002-03 (financial year of purchase) and 480 (financial year of sale) for 2004-05. Thus the cost becomes Rs 10,738 (Rs 10,000 X 480/447). The profit comes to Rs 3762 and the tax at 20 per cent of this at Rs 752. Since the tax in the first working at Rs 450 is lower the individual can choose this as the tax to be paid.

Short-term gains

If an equity oriented fund is sold within a year of purchase then the gains that arise are referred to as short term capital gains and are taxed at 10 per cent. Consider an investor who buys 1,000 units of an equity fund at Rs 24 per unit and sells them after four months at Rs 29 per unit. In this case the profit is Rs 5,000 and the tax on this will come to Rs 500 at 10 per cent.

The short term gains that occur on debt oriented funds will have a different impact as this will be added to the income of the individual. Depending upon the tax slab that the individual falls under, the appropriate tax would be calculated.

For instance, if a person buys 1,000 units of a debt oriented mutual fund at Rs 12 in June 2006 and then sells it for Rs 13 in December 2006 then the gain of Rs 1,000 is short term in nature. If the individual has a total income of Rs 350,000 then this will be added to the total income and in effect the tax on this Rs 1,000 will be at the highest slab of 30 per cent.

As one can see there are different methodologies involved to arrive at the right number when one is calculating tax on capital gains. An appropriate classification is always important along with the right calculation of tax to make the process effective.