Taxation

Tax is where a distributor earns trust: a client remembers the person who told them the right holding period before they redeemed. The rules changed in July 2024 and again with the Income-tax Act, 2025 taking effect on 1 April 2026, so the exam is testing the current numbers. Learn the classification first; every rate follows from it.

Step one: classify the scheme

For tax, a mutual fund scheme falls into one of three buckets based on its portfolio, not its name.

• Equity-oriented scheme: at least 65% of assets in domestic equity shares (measured as the annual average of monthly averages). This includes large, mid and small cap funds, flexi cap, ELSS, aggressive hybrid, arbitrage, equity savings, and fund of funds that invest predominantly in equity ETFs.
• Specified mutual fund (debt-type): a scheme that invests more than 65% in debt and money market instruments, or a fund of funds investing in such schemes. Units bought on or after 1 April 2023 are taxed at the investor's slab rate regardless of the holding period; the gain is always short term.
• Everything else: hybrids with 35% to 65% equity (balanced hybrid, many dynamic asset allocation funds), gold funds, international funds, and other fund of funds. Long term after 24 months, taxed at 12.5%; short term at slab.

Capital gains: rates and holding periods

A gain arises on redemption, on a switch (which is a redemption plus a purchase), and on the transfer of units. The rates in force:

• Equity-oriented, held 12 months or less: short-term capital gain taxed at 20%.
• Equity-oriented, held more than 12 months: long-term capital gain taxed at 12.5%, with the first ₹1.25 lakh of such gains in a tax year exempt. Gains on units bought before 1 February 2018 are grandfathered: the cost is stepped up to the NAV on 31 January 2018 where that is higher.
• Specified (debt) funds bought on or after 1 April 2023: slab rate, whatever the holding period. Debt units bought before that date and sold after 23 July 2024 qualify as long term after 24 months and are taxed at 12.5% without indexation.
• Other schemes (35 to 65% equity hybrids, gold, international): short term at slab if held 24 months or less; long term at 12.5% beyond that.

Surcharge and the 4% health and education cess apply on top. Securities transaction tax of 0.001% is paid on redemption of equity-oriented units (not on purchase); it is a cost of transfer, not a creditable tax. Stamp duty of 0.005% paid on purchase forms part of the cost of acquisition.

Had the same investor redeemed at 11 months, the entire ₹2,50,000 would be short term at 20%, or ₹50,000 plus cess. That one-month difference is ₹35,000 of tax.

SIPs and FIFO. Each SIP instalment is a separate purchase with its own date and cost. On redemption, units are deemed sold on a first-in, first-out basis. After 15 months of a monthly SIP, only the first three instalments have crossed 12 months; a full redemption would produce a mix of long-term and short-term gains. Set-off: short-term capital losses can be set off against short-term or long-term gains; long-term capital losses only against long-term gains. Unabsorbed losses can be carried forward for 8 tax years if the return is filed on time. Losses cannot be set off against salary or business income.

IDCW, TDS and NRIs

IDCW (dividend) received from any scheme is added to the investor's income and taxed at the slab rate. The AMC deducts TDS at 10% if IDCW paid to a resident exceeds ₹10,000 in a tax year; an investor with no tax liability can submit Form 15G or 15H to avoid the deduction. This makes the IDCW option tax-inefficient for investors in higher slabs compared with the growth option, where tax arises only on redemption at capital gains rates.

For non-resident investors, the same capital gains rates apply, but the AMC deducts TDS on gains at the applicable rates at the time of redemption (20% on short-term equity gains, 12.5% on long-term equity gains, and slab-equivalent rates on debt, plus surcharge and cess). A lower rate under a Double Taxation Avoidance Agreement can be claimed with a tax residency certificate. NRIs file returns in India to claim refunds of excess TDS. Residents face no TDS on capital gains from mutual funds; they pay through advance tax or self-assessment.

ELSS and the Income-tax Act, 2025

The Income-tax Act, 2025 replaced the 1961 Act from 1 April 2026. It uses the single term tax year instead of previous year and assessment year, and renumbers sections. The old Section 80C is now Section 123. Investment in an ELSS qualifies for a deduction of up to ₹1.5 lakh a year under Section 123, shared with PPF, EPF, life insurance premium and the other items in that basket, and available only to taxpayers who choose the old tax regime. Under the default new regime there is no Section 123 deduction, so an ELSS competes on its merits as an equity fund.

ELSS units carry a 3-year lock-in from the date of allotment of each instalment. A SIP into an ELSS therefore has 12 separate lock-in dates a year. After the lock-in the units are redeemable and the gains are taxed like any equity-oriented scheme: 12.5% beyond ₹1.25 lakh. Retirement and children's solution-oriented schemes do not qualify for Section 123 unless notified; their lock-in is a scheme feature, not a tax benefit. The securities transaction tax, stamp duty and exit load are not deductible as separate items; stamp duty increases cost, while STT is simply a cost of sale.

Two practical reminders for client conversations: a switch between schemes, or from regular to direct, is a taxable redemption even though no money reaches the bank account; and a transfer of units by gift or inheritance is not a transfer for capital gains, with the recipient inheriting the original cost and holding period.