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Little-known tax benefits of investing in mutual funds

July 26, 2007 16:03 IST

Among the innumerable investment options currently available to investors, investment in mutual funds is one of the more popular ones.

The reasons are not far to seek: for an individual investor it is very difficult to keep abreast of the latest changes and the happenings whether in the stock market or fixed income instruments.

Besides, the liquidity that investment in mutual funds offers has also given a fillip to their increasing popularity. Most mutual funds nowadays provide investor friendly procedures which are easy to manage and handle.

The transfer, transmission and nomination of the units of mutual funds are comparatively easy and simple.

Which is why in the last two or three years in particular, investment in mutual funds has seen a steep growth. Then, too, mutual funds come loaded with terrific tax advantages.

Dividends are tax-free

The biggest tax advantage of investing in mutual funds arises from the provisions contained in Section 10(35) of the Income Tax Act, 1961, under which the entire income received by investors, whether from units issued by Unit Trust of India or those of any other mutual fund registered under the Securities and Exchange Board of India (Sebi), is fully exempt from income tax.

This complete exemption of income is applicable for all categories of taxpayers. As a result of the full tax exemption on income from mutual funds, the after-tax yield to the investor is higher in comparison with other comparable instruments available in the market.

Low or zero tax on capital gains

In the case of non-equity funds -- namely mutual funds investing in debt, government securities, as also some exposure to equities -- when units of mutual funds are sold after holding them for more than 12 months, there is a concessional rate of tax @ 20% on long-term capital gains after making appropriate adjustment for Cost Inflation Index.

If the investor chooses not to take advantage of the Cost Inflation Index, then the concessional rate of income tax payable would be only 10%. In view of the concessional rate of income tax payable on long-term capital gains, investment in mutual fund becomes a very lucrative option.

In the case of equity funds, namely for mutual funds investing mainly is shares there is zero-tax liability on long-term capital gains, while the tax rate would be 10% for short-term capital gains.

Tax Smart 1: The lesser-known Gift Tax benefit of mutual funds

In view of abolition of Gift Tax with effect from 1-10-1998, mutual fund units can be gifted to one's relatives without any liability of gift tax.

However, gift should be avoided to one's spouse and daughter-in-law in view of the clubbing provisions of Section 64 of Income Tax Act. This is a well-known fact.

Now, for the little-known Gift Tax benefit of mutual funds: as per law, gift of any sum received from non-relatives in excess of Rs 50,000 in a financial year is currently to be added to the total income of the recipient.

Mutual fund units, however, are an exception. The gift of units of mutual fund from non-relatives would not attract this annual limit of Rs 50,000. Thus, without any upper limit the gift in the form of units of mutual fund can be received even from non-relatives with no tax liability whatsoever.

Tax Smart 2: Taking a loan to invest in income funds can be a good idea

'Finance available against shares,' 'Unlock the value of your demat shares,' 'Bank loans on shares' -- various loan packages are now available to investors for buying shares and mutual fund units. Such loans can provide easy liquidity without having to divest your portfolio.

Salaried professionals, self-employed persons or individuals having an independent source of income are eligible to take loans against your share and mutual fund portfolios.

Let us see if there is any tax benefit in going in for such loans for buying additional mutual fund units?

Ultimately, it is the utilisation of loan funds which determines the deductibility or otherwise of the interest on the loan taken.

And, in most cases, taking a loan by pledging one's shares and mutual fund units as a security offers no tax benefit to the investor.

This is because Finance Act, 2001 had retrospectively inserted Section 14A in the Income Tax Act to specifically provide that expenditure incurred in relation to income not includible in the total taxable income would not be allowed as a deduction.

This means that an investor cannot deduct the interest on the loan amount from the income received in the form of dividend from shares or mutual fund units bought out of a loan amount since dividend income is completely exempted under the Income Tax Act, 1961 as per the provisions contained in Section 10(34) and 10(35) of the Income Tax Act, 1961.

Let us now see what happens if you buy shares or mutual fund units by taking a loan against his or her existing portfolio of assets and mutual fund units.

During the holding period of the shares, he receives dividends, and finally sells them. In this situation, the interest paid in respect of the loan will not be allowed as a deduction from the dividend income which is in any case completely tax-free.

However, when the shares are sold at a later stage and capital gains result, then this interest on loan would be allowed as a deduction from the capital gains. This benefit deducting the interest amount from the capital gains - or capital loss - will be available both in the case of long-term capital gains (holding period longer than 12 months).

Let us now turn to the case of capital gains made on the sale of mutual fund units purchased using a loan. As per Finance (No.2) Act, 2004 the income arising from long-term capital gains from shares as also equity mutual funds is tax-free.

Thus, if a loan is taken to buy units of equity funds units, there is no tax advantage in respect of interest paid on the loan.

On the other hand, you can deduct the interest paid from capital gains arising from income funds, as also balanced funds, which have less than 65% in equity. And this can give an additional fillip to your effective returns from investment in non-equity funds.

Excerpt from:

51 Income Tax Tips for Investors

by Subhash Lakhotia

Price: Rs 145

Subhash Lakhotia has been an income-tax practitioner for nearly 30 years and is the author of a number of books. He also writes regularly in the financial press.

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Subhash Lakhotia