MUTUAL FUNDS AND THEIR TAXATION

Dr. Somesh Kr. Shukla, Reader,

Shobhit, Research Scholar,
Department of Commerce,
University of Lucknow.

INTRODUCTION
A mutual fund is a diversified portfolio of stocks, bonds and other
securities. A mutual fund is a financial intermediary that pools savings and
surplus of the community and invest it in fairly large and well diversified
portfolios of sound investments according to the investment objectives of
the investor. The biggest selling point of these mutual funds is supposed to
be professional management and the easy investment procedure. The
objective is to maximise the return to the investor who participate in equity
indirectly through mutual funds.

INVESTORS

INCOME/DIVIDEND/ PROFESSIONAL
APPRECIATION MANAGER (AMC)

STOCK MARKET

MUTUAL FUNDS OPERATIONS: FLOW CHART

ORIGIN AND DEVELOPMENT OF MUTUAL FUNDS

The concept of mutual fund originated in England and later found its
way to United States in 1924. The credit for visualisation and advent of the
concept of mutual funds in India goes to Unit Trust of India, which was set
up by an Act of parliament namely UTI Act (1963) in 1964.The public
sector banks1 and financial institutions2 began to establish mutual funds in
1987 which were later regulated and registered under the Securities and
Exchange Board of India Act, 1992 or regulations thereunder. The private
sector and foreign institutions were allowed to set up mutual funds in 1993.
Today there are around 34 mutual funds with approximately 500 products
classified under a dozen generic heads. The total investible funds of the
industry grew from Rs. 24 crores in 1964 to more than Rs. 1, 20,000 crores
in 2002. Here an effort is being made to study the various tax aspects
relating to mutual funds in India.

TAX BENEFITS TO MUTUAL FUNDS

Mutual funds in India have a special feature as to Income Tax
provisions. Under section 10(23D) of Income Tax Act, 1961, a mutual fund
has been conferred total tax exemption from income tax on all its income
provided it is a recognised fund. Recognised mutual fund implies that the
fund should be registered under SEBI3 (Mutual Funds) Regulations, 1992
or regulations made thereunder. Mutual funds set up by a Public sector
bank, Public financial institutions or authorised by Reserve bank of India
and subject to the conditions specified by Central Government in this
behalf shall be exempt from Income tax. Income accruing to Asset
Management Company by way of dividends or by way of capital gain is
totally exempt. This is meant to provide a much higher yield to the mutual
funds to enable them to distribute a higher return to the investors.
According to Union Budget 2002-03, Mutual Funds are also relieved
of the tax liability as the incidence of tax is shifted on to the unit holders of
UTI and other mutual funds and thus sub-clause (ii) and (iii) of clause 33
of section 10 are omitted. This position has been reversed in the Union
Budget 2003-04. Now, the mutual funds are liable to pay the income
distribution tax.
 Incomes from investments are otherwise taxable but under income
tax act, mutual funds are treated as pass through entities since they invest
funds of public and earn income on their behalf. It implies that whether the
income is in form of dividends, interest, underwriting commission or
capital appreciation, the income of mutual fund is not taxable. The practice
world over is similar but full immunity is granted to the fund, only if a
specified amount is invested in equity shares to ensure that major income
is a post tax income. Further as per section 115A of the Income tax
Act,1961, it is added that the deductions under sections 80CCC to 80U are
not available against the income received in respect of units purchased in
foreign currency, of a mutual fund specified in section 10(23D) or of the
U.T.I. and tax is to be paid @20%

(1) Public sector bank’s means the state bank of India constituted under the state
bank of India Act 1955, a subsidiary bank defined in the SBI (Subsidiary Bank) Act
1959, a corresponding acquisition and transfer of undertaking act 1970 or u/s 3 of the
banking companies’ acquisition and transfer of undertaking Act, 1980.
(2) The expression “public financial institution” shall have the same meaning
assigned to it in section 2(1) (a), of the Companies Act, 1956.Some of the Public
Financial Institutions are ICICI Ltd, IDBI, IFCI, LIC, and UTI.
(3) The expression “Securities and Exchange Board of India” shall have the same
meaning assigned to it in section 2 (1) (a) of the Securities and Exchange Board of
India Act 1992.

TAX BENEFITS TO INVESTORS

 The income received by the investor of mutual funds is taxable in
their hands unless these are capital redemption. One of the reason for
mutual funds scheme being quoted at discount to NAV was the differential
in tax treatment to equity shares and mutual funds units, which made
investment in mutual funds less attractive than the equity. Before budget of
1994-95, units to claim benefits of capital gains u/s 48 were to be held for
more than 36 months but this budget removed this anomaly and put the
mutual funds units at par with equity shares. As a result an investor,
holding shares in a company directly or through mutual funds will now be
eligible to the benefits of capital gains tax at consessional rate. Investors
are likely to come flocking to Mutual funds to claim capital gains tax.
Similar concessions are available to Foreign Financial Institutions (FFI’s)
for their investment in mutual funds i.e. low capital gains tax if units are
held for more than 12 months instead of more than 36 months.

Tax on income distributed by a Mutual Fund

According to section 115R, 115S, and 115Tof the Income Tax Act,
1961, the Mutual Fund shall pay tax @ 12.5% plus surcharge, if any on the
income distributed to its unitholders for the assessment year 2003-04 (for
A.Y.2004-05 @ 2.5%).However tax shall not be chargeable for any income
distributed to a unit holder of open ended equity oriented fund for a period
of one year commencing from 1.4.2003. It is hereby worth mentioning that
the mutual fund shall be liable to pay the amount of tax to the credit of the
central government within fourteen days from the date of distribution or
payment of income, whichever is earlier, to the unitholders, failing which
the mutual fund is liable to pay a simple interest of 1.25% every month for
the amount of tax it fails to pay. Further, MF’s are not allowed any
deduction in respect of such income that has been charged to tax.
 Mutual funds have to furnish information to the prescribed income
tax authority on or before 15th September each year in a prescribed form
giving details as under
1. The amount of income distributed to the unitholders during the
previous year
2. The tax paid thereon
3. Such other relevant details as may be prescribed.

Payment on account of Repurchase of units by Mutual Funds or Unit

Trust of India (194F)
The person responsible for paying to any person any amount on
account of repurchase of units or termination of the scheme (referred to
in section 80CCB (2) of Income Tax Act as equity linked saving scheme
shall, at the time of payment thereof, deduct income tax thereon at the
rate of 20% plus surcharge @ 2 % of such tax. The rate of surcharge has
been raised to 5% for the financial year 2002-03.
These payments include:
• Payment against investment made in units of any mutual funds
specified u/s 10(23D) of the Income Tax Act, 1961.
• Payment against investment in units of UTI.
However, the aforesaid investments should have been made on or
before 31-03-1992 in accordance with ELSS as notified by the central
govt. obligation to deduct tax at source arises only with reference to
amount (investment) as referred to in section 80 CCB (1) of the Income
Tax Act, 1961 and not with reference to the capital appreciation
comprised in the payment.
Where any amount invested in respect of which deduction u/s 80
CCB is allowed is later returned to the assessee in whole or in part either
by way of repurchase of units or on termination of the plan in any
previous year, the income so returned shall be treated as the income of
the assessee for that previous year and brought to tax. The difference
between repurchase price of the units and amount invested therein shall
be deemed as capital gains and charged to tax.
According to section 194F, person responsible for paying any person
any amount referred to in section 80CCC(2) shall, at the time of payment
thereof, deduct income tax thereon @20% plus surcharge. It means tax
shall be deducted on the principal amount at the time of repurchase of the
units and not on the whole amount paid at the time of repurchase of units.
It is further revived that u/s 196A, tax shall be deducted at source for any
income paid to a non resident not being a company, or to a foreign
company in respect of units of UTI and Mutual Funds at the rate of 20%.
The provisions relating to tax deduction at source under section 194F and
196A are effected from 1st June 2002.
Further, the tax benefits of section 88 of the Income Tax Act, 1961 is
available to investor as, individual and HUF’s are entitled to rebate from
the amount of income tax on his total income which is chargeable for any
assessment year if sums are paid or deposited by assessee out of his
income chargeable to tax in respect of subscription not exceeding
Rs.10,000/- in units of any mutual fund notified under clause (23D) of
section 10 of the Income Tax Act,1961, or of Unit Trust of India and also
on the contribution to any pension fund set up by any mutual fund or Unit
Trust of India.
For assessment year 2003-04 ; Under clause v and va of section
80L individuals and HUF’s are eligible to a deduction from dividend
income upto a maximum limit of Rs.12,000/-. The above clauses are
omitted w.e.f. A.Y. 2004-05.

TDS from income distribution

 Income distribution from mutual fund is not free from TDS
provisions. A mutual fund has to deduct TDS where the income
distribution exceeds Rs. 2,500 in a financial year. According to section
194 F. of Income Tax Act, 1961, for the financial year 2003-04, tax is to
be deducted at source in the case of a person other than a company when
the person is resident in India at the rate of 20% for payment on Account
of repurchase of units by mutual funds or unit trust of India (section 80
CCC).

CONCLUSION AND SUGGESTIONS

Mutual funds have received a boost, with dividends being made tax
free in the hands of investors, which on one hand would reduce
regulatory compliance and on the other, it would lead to a reduction in
tax implications for those in higher tax brackets, the cause being 12.5%
distribution tax payable by mutual funds is lower than the 30%, an
investor in highest tax bracket has to pay. Further equity funds and UTI -I
schemes have been exempt from paying the distribution tax which will
prove to be an incentive for investors taking the mutual funds route to
participate in the equity market.
Contrary to the international practice of segregating mutual fund
income into short term capital gains, current incomes and long term
capital gains, Indian funds do not split their incomes on this pattern.
Thus, irrespective of nature of income of mutual funds, income in hands
of investors are treated as dividends, it is known that tax rate for long
term capital gains is lower than tax on dividends (which varies as per the
tax slab of the investors). Some funds operating pure equity growth
schemes have been declaring annual dividends, which should be
distributed as capital appreciation, consequently put investors
 (presuming, they have exhausted dividend exemption limit u/s 80L) to
great disadvantage.
Thus it is desirable on part of SEBI to insist on mutual funds to
segregate their earnings into current income and capital gains instead of
the present practice of considering all types of income being the same.
Secondly, the amount distributed as dividend should also be splitted up
into current incomes and capital gains giving opportunities to investors to
avail all tax concessions.
Further, it is also advisable that there should be exemption from tax
on dividends as to avoid double taxation, steps should be taken to make
mutual fund an ideal investment vehicle as mutual funds promote growth,
along with capital appreciation which in turn helps in the development of
the economy.

REFERENCES:
Association of Mutual Funds in India yearbook-2000
Association of Mutual Funds in India Update Jan-Mar 2001 issue
Mayya, H.R-2000 Few Thoughts on functioning of Mutual Funds,
Chartered Secretary 30(12) 1515
Shashikant, Dr. Uma- Invest India courses on Mutual Funds
Bansal, Lalit. K- Mutual Funds – Management and Working 2000
Srivastava, R.M.-Essentials of Business Finance 2000
Machiraju,H.R.-Indian Financial System 2002
Bhole,L.M.-Financial Institutions & Markets–Structure, Growth and
Innovations 1999
Bhalla, V.K.- Management of Financial Services 2002
Thomas, Susan (Ed). Fund management in India 1999
Trivoli, George W. Personal Portfolio Management2000
REFERENCE MAGAZINES AND NEWSPAPERS:
Outlook money
Businessworld
Investment Monitor
The Economic Times
REFERENCE WEBSITES:
www.myiris.com
www.amfiindia.com
www.mutualfundsindia.com
www.indiainfoline.com
www.ici.org
and several other investment related websites of Mutual Funds and Asset
Management Companies (AMC’s).