Tax Benefits of Mutual Funds in India

Tax is a certainty when you go out to invest in any scheme. But one has to look at various aspects to avoid such taxes. Many people who invest in Mutual Funds look out for Tax-savings. The Government of India revised various Taxation schemes for providing tax-benefits to the investor.

Starting from, April 1, 2003, all dividends distributed to investors by debt-based mutual funds were exempted from taxes. However, Mutual Funds were required to pay a dividend distribution tax of 12.5% including surcharge on the dividends. Under Section 88 of Income Tax Act, 1961 ELSS-equity-linked savings schemes can benefit by a tax-rebate on investment up to Rs 10,000 under certain pre-stated conditions. Depending on whether mutual fund comes under short-term capital asset or a long-term one, the units are liable to taxes. The Section 2(42A) describes mutual fund as short-term capital asset if it is held for less than a year whereas if the units held for more than a year they come under long-term capital asset.

Section 10(38) of the Income Tax Act exempts long-term capital gains, occurring from reallocation of a unit of mutual fund, from taxes. The rule came into being after October 1,2004 so tax is exempted if the transaction took place after this date. This rule requires the securities transaction tax is paid to the appropriate authority.

The Section 111A of the Income Tax Act states that the short-term capital gains that crop up from transfer of a unit of mutual fund is taxable@ 10% plus applicable surcharge. This is applicable to all transactions that take place after October 1, 2004 and also the securities transaction tax is paid.

Under section 88E of Income Tax Act, the security transaction tax can be rebated if the transaction represents a business income.

Capital gains are calculated after considering cost of realization as adjusted by Cost Inflation Index stated by the central government.

The Section 112 of the Act states that capital gains that are not roofed by the exemption under Section 10(38) come under various categories of taxable long-term capital gains and charge rates of tax depending on the category. A resident individual and HUF is charged 20% (plus surcharge). All Indian companies and partnership firms are taxable at 20%( plus surcharge). Whereas the foreign Companies are liable to pay 20% tax (plus no surcharge).

The unit holders are liable to pay taxes. They pay a 10% tax plus applicable surcharge if they don’t opt for the cost inflation index benefit and if they take advantage of the cost inflation index benefit they are charged 20% tax with applicable surcharge.

Under Section 115AB of the Act, 1961, long-term capital gains considered as units acquired in foreign currency by an foreign financial organization kept for a period of more than one year will be taxed@ 10%(no surcharge). The gains don’t take into account cost of acquisition.

Under Section 2(EA) of the Wealth Tax Act, 1957, units held under Mutual Funds are not liable to Wealth tax, as they are not treated as assets. Moreover units of Mutual Fund can be given as gift, thus is not liable to gift tax i.e. no tax is payable by donor or donee.

Under Section 115E of the Act, for a non-resident Indian capital gains chargeable on reallocation or transfer of long-term capital assets are taxable. If they form an Investment income, they are charged @ 20% and long-term capital gains are taxed @ 10%.

Under Section 10(23D), income of any form received by the Mutual Fund is exempt from tax. However the Income distributed to a unit holder of a Mutual Fund is taxable under Section 115R. Income distributed to individual or HUF is taxable @ 12.5% and others are taxed @ 20.0%. This tax is excused for open-ended Equity Oriented Funds.

Purchase Redemption and Repurchase Price

Under various schemes offered by the Mutual Fund, the units of funds are purchased, redeemed, and repurchased. These prices vary according to the type of funds one deals in and the fund’s portfolio must be thoroughly studied before investing in y\the fund.

Purchase Price

Purchase price or sales price is the price paid to buy one unit of the fund. However, the fund can be loaded or it can be a No Load fund. In the former case when fund levies an entry load then the purchase price will be greater than net asset value of the fund. The price will depend upon the entry load levied on the fund. For a ‘No Load’ fund the purchase price is same as NAV. Generally, Funds charge an entry load between 1% and 2%. Exit loads range from 0.25% and 2.00%.

For e.g. Say an investor invests Rs 20,000/- and the current NAV is Rs.20/-. The entry load levied by the Mutual Fund is 1.00%; the price at which the investor invests is Rs.20.20 per unit. Units in a Mutual Fund are allotted to an investor depending upon the amount invested; it is not on thee basis of number of units purchased.

The investor receives 20000/20.20 = 990.099 units.

Now suppose the same investor decides to redeem his 990.099 units. The current NAV is Rs 25/- and the exit load is 1.25%. So the sale or redemption price per unit becomes Rs. 24.9875. The investor therefore gets 99.099 x 24.9875 = Rs.24762.3626.

So the purchase price here is Rs20.20 per unit as the investor has to pay the toll tax for entering the mutual fund bridge. Had it been a NO Load fund the purchase price would have been Rs 20.

Repurchase price

Generally, a Close-ended Fund has a fixed maturity period that range from 2 to 14 years. They sale only a fixed number of shares in the initial public offering after which the shares typically trade on a secondary market. The cost of closed-end fund shares that do business on a secondary market after their initial public offering is totally dependent on the market and doesn’t depend on the initial NAV. It may be more than or less than the share’s net asset value. Repurchase price is the price paid by a close-ended scheme to repurchase its units that are trading in the secondary market. The repurchase price can either be the NAV or it might have an exit load associated with it.

Redemption Price

Redemption price is the price received by the investor/customer on selling units of an open-ended scheme to the fund. In case of funds that does not levy an exit load the redemption price is same as the net asset value. However, in case the fund levies an exit load, the redemption price is lower than the net asset value. In that case the exit load percentage is subtracted from the NAV at the time of redemption of the fund.

Evaluation Criterion while buying a Mutual Fund

There are various aspects that should be looked into before putting your money into the Mutual Funds.

First of all the prospectus or the offer document must be studied in detail before investing. Various aspects covered must include:

Main features of the scheme followed: A Mutual Fund offers various schemes that are categorized according to investment objectives and Maturity period. Open-ended scheme doesn’t have a fixed maturity period and investors can buy or sell shares at any time based on NAV that is declared on daily basis. This scheme offers the highest liquidity. However, a closed-ended scheme has a fixed maturity period of 5-7 years. Based on investment objective, a scheme can be classified as growth scheme, income scheme, or balanced scheme. An investor, depending on his finances, risk-taking capacity, age etc, can take up any of the offered schemes.

Entry or Exit Loads: Some Mutual Funds offer a sales charge or load, which is to be paid when shares are bought or redeemed. There are some funds with no sales charge; these are called No Load Funds. Before investing the funds must be checked for the load they charge. However, it is meaningful to pay a load if fund gives a better investment than No-Load fund.

Risk factors involved in investment: Mutual Funds do not guarantee sure returns. These returns are related to the functioning of these funds. Mutual Funds invest in deposits, shares and debentures. There is some amount of risk associated with investment. The percentage may vary according to the working of the company or different companies may fail to pay the interest or principal amount on their securities. Government might change the rules regarding certain industries thus directly affecting the mutual bonds – this factor must be kept in mind while investing particularly in Sector funds.

Initial issue operating cost: One must check up with the offer document of the mutual fund for initial operating cost

Recurring Expenses that are to be charged: Again before investing all the expenses that are to be paid again and again must be kept in mind.

History of Mutual Funds: The Company’s profile, its profits, portfolio and competence must be the first thing to check up before taking up an issue. Moreover if you are investing in one scheme of he mutual fund the track record of performance in other schemes launched must be checked up.

Type of Securities that the fund invests in: One must see to the bonds, debentures and other stock options that the mutual funds invest in. The market value of these securities must be considered before investing.

Professional qualification of the person handling the funds: The financial handler of mutual funds must be a professional with good experience in the particular field. It is his duty – what to buy, when to buy, keeping a close watch and when to sell off. Handling this collective investment is a major issue and must be given in safe hands.

Penalties, if any, to be imposed: The offer document of Mutual Funds must be read carefully for any kind of penalties imposed under any circumstances. 

Different Schemes under Mutual funds

Tax Saving Schemes

These schemes give tax rebates to the investors under explicit requirements of the Income Tax Act, 1961 as well as saving in Capital Gains under section 54EA and 54EB, as the Government offers tax incentives for investment in particular avenues. Pension schemes offered by Mutual Funds, equity linked savings schemes are allowed as deduction under Section 88 of the Indian Income Tax Act, 1961. For example investing in diversified equity fund will never give you any tax benefits whereas investing in ELSS will show the tax benefits in the year of investment itself. The amount you invest in one financial year (April 1 to March 31) will be deducted from your taxable income that year. Tax-saving schemes mainly aim towards growth so they basically invest in equities. However, the risks associated with them are similar to any equity scheme.

Index Schemes

Under this scheme the mutual funds also called Index Funds imitate the performance of a specific index. The American index that is most commonly imitated is the S&P 500 by buying all 500 stocks using the same value as the index. BSE Sensex, the NSE S&P CNX 50 in India, NASDAQ 100, Russell 2000, MCSI-EAFE, Wilshire 5000 etc are the other popular stock indexes followed. These funds invest in a set of securities which moves according to a popular index used as a benchmark.and are called passive funds. The index determeines the choice of investments thus leaving the fund manager with no research on securities. However he only needs to adjust the funds i.e. buy and sell shares with change in Index. Thus the passive performance of funds is obvious causing a lower expense as compared to actively managed funds. The net asset value in Index schemes is directly proportional to the index they follow. However due to some factors such as tracking errors the percentage of change varies with each security. This variation is always mentioned in mutual fund document provided.Traditional Index schemes allow the change the share price only once a day. A new type of funds – Exchange-traded funds(ETFs) have a different approach. These index funds sell shares at a price that changes throughout the day, thus increasing the liquidity. Their practical approach have made them a hot cake financial tool with a bright future.

Sectoral Schemes

Sectoral Schemes are the ones that invest solely in particular sectors such as Fast Moving Consumer Goods (FMCG), Metal Industry, Information Technology, Petroleum Stocks, and Pharmaceuticals etc. The profits are dependent on the performance of particular industries. Unlike the equity schemes the portfolio of these schemes is limited to the particular sectors or industries. Therefore the risk factor associated with these schemes is usually high. A close watch on the rise and fall in the values of these securities is a must in order to avoid any unexpected results. Thus the user must exit from the scheme once there is a fear of losses in that particular sector else there is a risk of losing investment.

Why the market falls faster than it rises?

Almost everyone who has been in the market must have noticed that shares fall faster than they rise.  This article looks at a couple of reasons because of which this happens. 

One reason why this happens is because of traders buying shares on margin money. This happens as follows. Suppose you have shares worth Rs. 1 lakh, on these shares your broker will allow you to take positions of say up to Rs. 40000. What this simply means is that you can buy and sell shares worth Rs.40000 without actually having to cough up this amount. This is called playing on margin money. In the above example the margin is 40%, which means that you can play up to 40% of the shares that you own. Every time the margin decreases below 40% you have to either square off the position or you have to keep extra cash with your broker. Now assume that you have also entered into such a trade where you had shares of say HLL worth Rs.1 lakh and you have bought shares of Infosys for Rs.40000 with the margin hoping to sell them off later in the day and make a quick buck. Unfortunately for you however the market falls and the value of HLL now remains only Rs.90000 whereas you have bought Infosys worth Rs.40000. To maintain the margin of 40% your broker calls you to pay up additional margin money (called margin call in market parlance). You decide that its not worth it and sell the Infosys that you have, further creating downward pressure and lowering the price of Infosys. If you look at the bigger picture and see the market as a whole there certainly will be another person who was holding Infosys worth Rs. 1 lakh and HLL worth Rs.4000, because of your decision this person would need to sell his HLL now. This is a vicious cycle in which many traders will now get trapped and what started off as a correction would result in a big fall. This is one of the prime factors why markets fall off sharply in a single day, the fall being anywhere close to 300 to 800 points on the BSE. 

Another reason why the market falls rather sharply is what is known as “Panic Selling”. What this means is that small and new investors in the market see that the market is falling and they think that there is no end to the fall. Often these investors enter the market with the lure to make big money and know little about what companies they are buying and have little confidence in their investment decisions. Such investors tend to sell all of their holdings in such falls and bail out of the markets. In the process they tend to drive the prices of the shares that they hold further down and end up pushing the prices abysmally low. 

The above two reasons are quite common and can be witnessed in every big fall that the market has. Its for you to understand these reasons and the next time you enter a trade be aware of such reasons and play the market carefully. Anyone who has been in the market will tell you that it is almost impossible to avoid such losses. So maybe you will lose money on such transactions as well. Considering the way the market has risen these days it is probable that the situation confronts you in the near future. You must not completely shun away from the market after such a situation but must understand the reasons, learn from them and not repeat the mistake. 

Penny Stocks

Penny Stocks have long been the attraction of a lot of investors because of the tremendous returns that these stocks can generate in a short period of time. The reason that some of these stocks are able to generate such high returns which goes as high as five or even ten times the amount invested is the price and the volume of these stocks are low.

Because the volumes are low in such stocks when interest is generated in such stocks and people start investing the sudden spurt in volume leads to a large increase in price of such stocks.

And that is the danger that exists while investing in these stocks. Because one can raise the prices many folds just by investing a few lakhs. Many a time these stocks are the target of Promoter manipulation.

The modus operandi is quite simple. A few promoters group together and generate artificial interest in a particular penny stock. Suppose there are two promoters who hold majority of the stock in their company where the volumes in the markets are low. Now one promoter will start selling his stock in the open market and the other promoter will keep on buying this stock at progressively higher prices. Since the volume is low the promoters are easily able to jack the prices by doing this. At the same time they also engage in spreading rumors about the company and create interest among the ordinary investors. They are easily able to prop up the prices from a low of say Rs.5 to a high of Rs. 20.

You can think of the two promoters as husband and wife and think that the husband has sold off all his shares to the wife and the wife has paid for the stocks. The net effect remains the same as the stocks of the couple remain with them and so does the money. Although in the real world the trade is more complex this analogy helps us to understand what exactly is going on in this transaction.

Now at the same time there is “real” demand for the stocks of the company in the market by investors other than the wife and it is at this time that the “wife” starts selling off chunks of her shares to the public at these propped up higher prices. Now because there is a genuine demand for those stocks in the market the prices do not fall as suddenly as they went up and this gives a good opportunity for the wife to get out of the stocks at a higher price than what they had originally had the shares for.

This is a neat way promoters have come up of making money in the penny stocks but at the same time other investors who are not well informed about the stock market become victims and lose their money in the deal.

This is not to say that all penny stocks will end up in losses, only to exercise caution while investing in the same and do some basic research before jumping into such penny stocks, which promise to triple in a month just because they have doubled in the last month. You need to look into why is it that they have doubled in the last month and get a sense of the safety that they offer before buying into it.

Mutual Fund Types

Any investor when making financial investments can follow only three important and distinctive objectives:

1. keeping the value of the invested money (investing in a monetary system that is stable to protect the income in under-evolved economies)
2. gaining a profit from the invested money (most typical example are the bank deposits that regulate pay out income under the name of interest)
3. increasing the value of the invested money (when investments are made in stocks or land/buildings) 

To satisfy the diversified objectives of the investors, the mutual funds administrators created three big fund types that have as a purpose meeting the respective objectives through different placement politics. Technically speaking the three types are: 

Ø Monetary Funds The monetary funds have as an investing objective keeping the value of the invested money. These types of funds are generally addressed to investors that, because of aversion towards risk or other motives (like needing the invested money in a short time), don’t want the value of their investment to decrease. Until now, in the USA, there has never been a monetary fund that ever signalized a decrease in the title value. 

The monetary funds can be successfully used to efficiently evaluate and sustain the current bank accounts (of individuals or companies). There are countries where payments can be made right out of the monetary fund, because sometimes these funds act just like a current bank account. Monetary funds invest usually in stocks that generate income and the variation in profit is very low. Their main investment areas are: national/state bonds, bank deposits, commerce effects emitted by commercial banks or commercial companies with an average withdraw limit of 90 days (they only choose low withdraw limits). 

Ø Income Funds  These funds have as an investing objective gaining a profit from the invested money or generating stable income. They are addressed to those that need supplementary stable income in addition to their current income. Since the majority of the incomes made by the fund are distributed to investors, the stock value doesn’t suffer significant variation. Still, because of the structure of the portfolio, there is a risk that the stock value would decrease.

Generally, investors in income funds are retired persons, young families or families that have to pay for their children’s studies. The investors can opt for cashing the distributed incomes or for reinvesting them automatically in the fund. The income funds will invest mostly in stocks that generate high incomes, but because of the long periods before withdrawal it is possible that they become exposed to value variations. The main investment fields are: bonds, asset mortgages, preferential stocks, common stocks emitted by very good companies with a rule of distributing consistent dividends. 

Ø Growth Funds Growth funds have as a primary objective increasing the value of the invested money (the value of the stocks). They mostly address those investors who wish for their investment to grow over time. The stock value will grow or decrease depending on the evolution of the stock market and the abilities of the investor.

The main categories that invest in growth funds are mature families that have already satisfied their basic material necessities (a house, a car and other assets) and they can afford to risk some of their current incomes with an investment that has a higher risk factor. Of course, in these kinds of funds the investors can also be persons with an appetite for risk. Within the category of growth funds we distinguish a different subcategory, named accumulation funds. These funds are the fund in which the investor, with the help of a contract sighed, has the responsibility to regularly invest in stocks (monthly, quarterly). Also they may sound like they belong to a different type, they are nevertheless growth funds.

A growth fund will invest in stocks whose value is considerably variable over time, any types of stocks, convertible bonds, options and futures contracts.

There are many other funds classifications, by the geographical zones they invest in, by the risk factor of the portfolio, etc., but, leaving these details aside, any fund will fit into one of the three categories presented above.