In the previous issue, we looked at the dividend distribution tax (DDT), which is applicable to dividend/income schemes of mutual funds. Besides the DDT, mutual fund investments are subject to the capital gains tax, which is applicable on the gains made on the sale of fund units. This tax is directly levied on investors, as opposed to DDT, which is charged to the fund.

Types of capital gains
There are two types of capital gains: short term and long term. If the units are sold within 12 months from the date of purchase, these are considered short-term capital assets and any gains arising from such sales are subject to short-term capital gains tax. On the other hand, if the units are sold after 12 months from the date of purchase, the units are considered long-term capital assets and any gains from such sales are subject to long-term capital gains tax. Here are the tax rates applicable to different mutual fund categories:

Equity schemes
The long-term capital gains are exempt for equity mutual funds, while the short-term capital gains are chargeable at the rate of 15%. The investors are also liable to pay the applicable surcharge, if any, and the cess.

Debt schemes
The IT act provides the benefit of indexation in case of long-term gains arising from the sale of debt fund units. The assessee can opt for one of the following rates:

1. 10% on the capital gain without the benefit of indexation.

2. 20% on the capital gain after including the impact of indexation.

The investor is also liable to pay the applicable surcharge, if any, and cess on the tax.

To some extent, indexation helps curtail the impact of inflation on the value of the investment. As rising prices erode the real value of investments, it is unfair on the part of the government to tax the value that has already been eroded. The indexation benefit compensates the taxpayer for any such erosion. This is calculated by inflating the purchase cost using the cost inflation index.

Let us look at the following example to understand the tax treatment of debt funds. In the financial year 2009-10, Mr A sold 500 units of a debt fund at Rs 18 per unit. He had purchased these in the financial year 2004-5 for Rs 10 per unit. The cost inflation index for the financial year 2004-5 was 480, and for 2009-10, it was 632. Mr A can choose any one of the following two methods:

The short-term capital gain on debt schemes is clubbed with the income of the investor and is taxed at the slab rate.

Assuming that the investor is in the higher tax bracket, the short-term tax rate works out to 30%.

The investor is also liable to pay the applicable surcharge, if any, and other cess on the tax.