Tax talks: Switching from dividend to growth option is taxable

I had invested Rs 3,00,000 in XYZ Equity Mutual Fund (dividend option) on February 20, 2018, for 10,000 units at Rs 30 per unit.

On April 1, 2019, this fund was merged with the company’s balanced advantage fund and my holding reduced to 8000 units for Rs 2,00,000 at Rs 25 per unit. 

On April 3, 2020, I switched to a growth option and was allotted 4,000 units at Rs 45 per unit. 

Now on May 4, 2021, the NAV of the fund jumped to Rs 90, and my investment value went up to Rs 3,60,000. If I sell now, how will long-term capital gain be calculated?

Reply:

The Income Tax Act states that any transfer resulting from the merger of two or more equity/debt-oriented funds shall not be considered taxable transfers by the unitholder. 

However, switching investments from one option to another under the same scheme will be considered redemption (sale). This switch will attract the exit load (if applicable) and capital gain tax. 

Hence, in the above scenario, there will be two incidences of taxation :

• Firstly, upon switching from the ‘dividend’ option to ‘growth’ on April 3, 2020.
• Secondly, upon final sale of mutual fund units on May 4, 2021.

There will be no tax implication in the merger of the mutual fund on April 1, 2019. 

The tax implication arises when switching the fund from one option to another. This is because the two options within the same scheme have different net asset values (NAVs) and operate differently. 

• A growth option in a scheme will reinvest the profits made by the fund, giving you higher returns with the power of compounding. This option is suitable for long term wealth creation.
• The dividend pay-out option shares profits made by the fund to its investors in intervals. The dividend option is suitable for investors looking for regular income from investments.

As per the above example, the switch was made on April 3, 2020, and so you will have to calculate capital gain on the redemption and report the same in the income tax return for FY 2020-21.

Likewise, the final sale of mutual fund units was made in May 2021; it will attract long-term capital gain for the FY 2021-22 (the return for which is to be filed next year).

Now, let us see how the period of holding for classification between long term and short-term gain will be calculated in all these instances:

• Holding the mutual fund units acquired by the assessee due to the merger of funds and later switched to ‘growth option’ shall be taken from the date of initial investment, which is February 2018.
• The holding period in case of the sale of mutual funds in May 2021 shall be taken from the switch to the growth plan (April 2020).

Now, for computation of capital gains, the nature of investment schemes shall have to be ascertained firstly. 

In equity-oriented mutual funds, capital gains will be the ‘long term’ if the holding period is more than one year. The same is computed by subtracting the acquisition cost (without indexation, after considering grandfathering provisions) from the sale consideration. The capital gains above Rs 1 lakh is taxable at 10%.

If the mutual funds are debt-oriented, they are considered long-term if held for more than three years; else, the same shall be regarded as short term. The short-term capital gains from debt funds shall be taxable at applicable slabs of the individual investor; long-term gains shall be taxable at 20% after indexation.

For FY 2020-21-Switching to growth option from dividend option

*Grandfathering rule will not be applicable as COA is after 31st January 2018. 

For FY 2021-22, the final sale of mutual fund units on May 4, 2021.

Assuming this is the only LTCG, then as it is less than Rs.1 lakh, the entire tax on LTCG will be exempt. 

For any clarifications/feedback on the topic, please get in touch with the writer at jyoti.arora@cleartax.in