Mergers of mutual fund schemes are quite common. The main reason for this is often that there are too many funds within the asset management company (AMC) with a similar objective. This automatically leads to higher costs for the AMC as it has to maintain records under different fund names, print different forms and so on. However, when this happens, there is a tax implication for individual investors.

Let us take a look at the merger process first. When two schemes merge, investors of the scheme which is being merged would get units of the scheme into which their fund has been absorbed. And the net asset values (NAV) of the two schemes determine the exchange of units at that point in time. Consider two schemes A and B where Scheme A is merged into scheme B. For the existing customers of Scheme B, there is no tax implication as there is no impact. However, for investors of Scheme A, the situation has changed now. The AMC follows a two-step process.

In the first step, units in the existing scheme are redeemed at the applicable NAV. This is because since Scheme A has been combined with Scheme B and that too, at the latter's NAV, the former ceases to exist. In the next step, the proceeds from the redemption in Scheme A are now invested in Scheme B at the existing NAV. There is a tax at this stage because of the redemption. There will be a capital gain or loss depending upon the NAV at which the units were redeemed in Scheme A. If the holding period is more than a year, the capital gains will be long-term. If the units have been held for less than a year, the gains will attract taxation under short-term capital gains. Also, the nature of a scheme will determine the applicable rate of tax on the gains. If the scheme is an equity-oriented scheme then the long-term capital gain will be zero, while the short-term capital gains will be taxed at 10 per cent. On the other hand, if the scheme that is merged is a debt-oriented scheme then the short-term gain will be  added to the income of the person while the long term gain will be taxed at lower of 10 per cent without indexation or 20 per cent with indexation.

Let us take an example. Consider an investor enters into a mutual fund by buying 1,000 units in an equity scheme on January 12, 2007 at Rs 14.55 per unit. This scheme gets merged with another after eight months in September 2007. The NAV at the time of sale of the units is

Rs 18.35. The gain works out to Rs 3.8 per unit or a total of Rs 3,800. Since this is a short-term capital gain in an equity-oriented fund, the tax works out to Rs 380 at 10 per cent plus education cess. But if the units had been bought a year earlier in January 2006, the entire gain would be tax free in the hands of the investor.

The writer is a certified financial planner.