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Taxation on mutual funds and tax offset provisions
November, 18th 2015

Income tax has its own set of complex rules and is vast and varied. One such area of complex rules is that of capital gains and related tax rules. 

Capital gain is the gain one makes from sale of a financial or non financial asset. Financial asset can mean equity shares, mutual funds, bonds, exchange traded funds, gold bonds and non financial asset would be real estate. Capital loss is the loss one makes from sale of financial and non financial assets. 

The time horizon to distinguish short term and long term capital gains or loss for financial assets is one year and non financial assets is three years with the exception of debt, bond and fixed income which fall under the category of financial assets, but as per Interim budget 2014, the time horizon for holding the fixed income category of financial assets, has increased from one year to three years.

Now let us look at the taxation of mutual funds, in which many retail investors prefer to invest. Below is a table showing the capital gains taxation on mutual funds for FY 2015-16.

For equity oriented schemes- Long term for assets held for more than one year and short term for assets held for less than one year.

For debt oriented schemes- Long term assets held for more than 36 months and short term for assets held for less than 36 months.

* Assuming the investor falls in 30% tax bracket. Alternatively the appropriate tax bracket in which the investor falls would apply.

What is Offset of Loss and how does one benefit from it?

Offset of Loss means setting off of losses of an asset (usually financial asset) from a particular source against gains of a financial asset from another source.
The objective of setting off losses in the current financial year or in the following financial years, is to reduce one's tax liability.

Broadly there are two types of loss adjustment

1.Current Year Loss Adjustment- This is the current year loss incurred that is to be adjusted against profits earned in another source in the same Financial Year.

For example, income earned from salary is Rs 10,00,000 in a financial year for an individual and he also owns a house property where the net annual value is negative or there is a loss of Rs 3,00,000. He can therefore, adjust the loss of income from house property, against the salary earned in the relevant financial year. 

Income from Salary: Rs 10,00,000
Loss from House property: Rs 3,00,000
Net Taxable Income: Rs 7,00,000

Following are the losses that can be offset against what type of income:

2.Brought Forward Loss Adjustment - This is a loss that is brought forward from the previous year that can be adjusted against profits from the current financial year.

Example- There is a profit from house property in the current Financial Year (FY), for Rs 6,00,000 and as per the above example there was a loss of income from house property of Rs 3,00,000 from previous FY. The person can adjust the loss of last year, against the gains of this year from house property.

That is Profit from house property in current FY Rs 6,00,000
Loss from house property in previous FY Rs - 3,00,000
Net taxable income is Rs 3,00,000

Below the table represents what losses from previous FY can be offset against gains from current FY.

Adjusting Loss Against Different income heads

Carry forward of losses
- For example in any FY, if the loss is huge and the full loss cannot be offset in one FY, you can carry forward the same for upto eight financial years.

Some losses can be set off only against the respective head of income. This is known as inter source adjustment. Some losses can be set off against different heads of income. This is known as inter head adjustment.

For example, one can offset, loss from business against salary income earned in a financial year. This is an example of inter head adjustment.

In the above example of brought forward losses, where there was a gain of house property in the current financial year and a loss from house property in the previous FY, the two could be offset within the same source or head and therefore, is called inter-source offset of losses.

For Mutual fund, equity, and bond investors, this is an important point to note,
Capital Losses (loss from sale of securities) can ONLY be set off against Capital Gains. (Income from sale of securities). However, the carry forward provision of losses still applies here.

Another point to note, is Long term Capital Loss can only be adjusted against Long term capital gains.

Whereas, short term capital loss can be offset against short term capital gains or long term capital gains.

Also, if the income from a particular source is exempt from tax, loss cannot be set off.

An example below illustrates the above scenarios-
Long term Capital Loss (LTCL) (equity) Rs 10,000
Short term capital gains (STCG) (equity) Rs 50,000
Long term Capital Gains (LTCG)(debt) Rs 15,000
Long term Capital Loss (LTCL) (gold) Rs 20,000
Short Term Capital Loss (STCL) (Equity) Rs 60,000
Long term capital gains (LTCG) (Equity) Rs 10,000

LTCL from Gold can only be offset against LTCG from debt. Therefore, although the loss from gold is Rs 20,000, only Rs 15,000 can be offset (long term gains from debt) Remaining loss of Rs 5000 cannot be offset.

The short term loss from equity(Rs 60,000) can be used to offset the short term gains made in equity (Rs 50,000), only to the extent of Rs 50,000, the remaining Rs 10,000 cannot be offset.

LTCL of Rs 10,000 from equity cannot be offset against LTCG of Rs 10,000 (equity), since LTCG from Equity is anyway, tax free!

A bit confusing, but when you apply it with an example, it becomes clear!

Hope this helps in understanding the basic concepts of taxation of mutual funds as far as capital gains is concerned and offset of loses against various heads.

It is prudent to always file returns on time and cross check your decision with a Chartered Accountant before filing returns of tax.

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