Mutual Funds: A Snapshot of Indexation Provision

An investor is mandated to pay tax on the profit earned through the sale of mutual fund units. This profit is referred to as capital gains, while the tax paid on such profit is called capital gains tax.

For instance, in case an investor purchases mutual fund units for Rs 10,000 and sells at Rs 11,000, they will have to pay tax on the gain of Rs 1,000. However, the rate at which the capital gains tax is levied depends on two factors, i.e. the period of holding and the type of the mutual fund scheme.

In this regard, indexation is considered while calculating the net tax liability on capital gains. The indexation provision under the Income-tax Act, 1961, aids in reducing the profit gap existing between the purchase price and the sale price due to inflation. As a result, this tends to have an effect in the form of a reduction in the net tax payable.

An investor can inflate the purchase price through indexation by a government-notified inflation factor, referred to as the Cost Inflation Index. At a time when the purchase price surges, the total profit experiences a dip; this, in turn, also affects the capital gain tax liability, leading to a reduction in its value.

However, to be eligible for the indexation benefit, an individual needs to invest in the growth option of the fund and remain invested for a minimum timeframe of three years.

As per the Finance Act 2023, indexation benefit on debt mutual funds is available no more. The Act states gains from the growth option of a debt mutual fund with less than 35% equity allocation will be taxed as Short-Term Capital Gains (STCGs), which is calculated at the marginal tax slab rate and does not take into consideration the holding period.

For instance, in case an investor is in the 20% tax slab, the STCG will be 20% of gains plus cess and surcharge, even if they hold the fund for over three years.

However, there is no change introduced in the taxation of equity mutual funds. Yet pure equity funds with over 65% allocation in equity do not extend indexation benefits.

In case an individual remains invested in the growth option of an equity mutual fund for over 12 months, they become eligible for Long-Term Capital Gains (LTCGs) tax, which is calculated at 10% plus cess and surcharge. In case the holding period is lower than 12 months, then gains will be taxed at 15% plus cess and surcharge.

However, the Finance Act has introduced the indexation advantage for a few funds having more than 35% but less than 65% allocation to equity. There are certain hybrid and multi-asset funds that allocate 35-65% in equity and may be eligible for the indexation benefit.

It is important to note that in case a hybrid or multi-asset fund has invested over 65% in equity, then it will be considered as an equity fund for tax purposes and becomes ineligible for indexation.

Ideally, an investor should check with the Assets Management Company (AMC) or a financial professional whether the fund in which they are investing is eligible to gain or not from the indexation benefit.