Jan 24, 2013

Tax Planning through Debt Mutual Funds

Who wouldn’t like a steady source of income? A steady income allows us the freedom to plan our expenses and life-style forward. It is for this reason that debt instruments like fixed deposits & bonds are so popular.

But, there is a catch with debt. What we get is fixed, but, what we spend need not be fixed. The money we require is bound to increase over time due to the phenomena of inflation. So be careful and invest your money wisely to beat inflation.

There is another very important draw-back of debt and that is the taxation. As per Indian IT Laws interest income earned on fixed deposits/bonds is treated as ‘income from other sources’ and will be taxed at the highest slab of the investor. So if you are earning more than 10 lacs in an annum, then 30% of whatever interest you get is eaten away by tax. Ouch! That hurts!

So what can be done about this?
Investing in mutual funds offers an alternative form of taxation. Mutual funds are treated as an asset according to IT laws. Now when we buy or sell an asset for a profit, it is treated as a capital gain. This asset could be land, gold, equity shares, bonds or mutual funds. Important to note that the interest I receive on a bond is ‘income from other sources’. However, if I sell the bond, then I have sold an asset, and therefore it is treated as a capital gain. Mutual funds work on the same principle. I buy in to a mutual fund (equity/debt) and, when I redeem, I sell the units. Therefore, I have sold an asset and the profit is to be treated as a capital gain. 

Capital gains are of two types- short term and long term. If you sell your debt mutual fund units within one year it is considered short term. If you hold it for 1 year or more and then redeem, it is considered as long term. 

Short term capital gain is taxed at the slab of the investor. So there is no difference in taxation between the interest incomes earned on FD’s/ bonds and short term capital gains on bonds/mutual funds.

However, the taxation magic works when you consider holding debt mutual funds for periods in excess of one year. Then your profit is long term capital gain. Long term gains are taxed at 10% flat or 20% inflation adjusted or indexed. 

Every year the Government of India announces an inflation adjustment rate for the purpose of long term capital gain. 

The cost inflation indexation chart is given below:

Financial Year
Cost of Inflation Index (CII)
1981 - 82
1982 - 83
1983 - 84
1984 - 85
1985 - 86
1986 - 87
1987 - 88
1988 - 89
1989 - 90
1990 - 91
1991 - 92
1992 - 93
1993 - 94
1994 - 95
1995 - 96
1996 - 97
1997 - 98
1998 - 99
1999 - 00
2000 - 01
2001 - 02
2002 - 03
2003 - 04
2004 - 05
2005 - 06
2006 - 07
2007 - 08
2008 - 09
2009 - 10
2010 - 11
2011 - 12
2012 - 13

How this works?

Suppose I’d invested Rs 1,00,000/- in a debt fund in financial year(FY) 2011-12 and redeemed the units at Rs 1,10,000/- in FY 2012-13. Then, my capital gain is Rs 10,000. I have the option of paying either 10% (+ cess) of this amount (Rs 1,000 approx) or indexed 20% of the capital gain. Let me illustrate the benefit of indexation.

The CII of FY 2011-12 is 785 & of FY 2012-13 is 852 (from table above). Now, to permute the tax we will need to calculate the indexed cost of purchase. Which is-

Rs 1,00,000 *852/785= Rs 1,08,535/-. [i.e purchase price * (CII of selling FY/ CII of purchasing FY)]

The above is considered to be the inflation adjusted cost of purchase.

My indexed capital gain is therefore= 1,10,000- 1,08,535= Rs 1,465/-

I will have to pay 20% of Rs 1,465/- as tax which will be approx Rs 300/-. In an FD/ Bond I’d have to pay Rs 3,000 approx in taxes. Big difference?

More magic…

Now, supposing I’d invested in a debt mutual fund in March 2011 and withdrawn my money in April 2012. The holding period is a little more than a year. But, tax-wise, it is 3 separate financial years. 2010-11, 2011-12 & 2012-13. Consider the same case as above. Now, CII of FY 2010-11 is 711 and 2012-13 is 852. So my indexed cost of purchase would be-

Rs 1,00,000 * 852/711= Rs 1,19,831.2/-

Now how much tax do I have to pay?
Indexed capital gain is Rs 1,10,000- Rs 1,19,831.2= -9,831.2.

I’m at a loss and not at a profit if we consider indexed purchase cost. Funny thing is I’m allowed to show this as a loss in my tax-filing. Yes, though I’ve actually made Rs 10,000/- it still counts as a loss according to the inflation indexed price. This is long-term capital loss. It can be carried on my books for a period of 8 years and be set of against any long-term capital gain. So, if next year I sell a property I can discount this Rs 9,831.2 on the profit and reduce my tax outflow.  Good deal?

This is the magic of investing in debt mutual funds and which many savvy investors are using smartly to reduce their tax outflow. There’s nothing illegal in what is being proposed above. It’s all according to provisions in the IT Act. This is an example of prudent tax planning

This is fine but we are talking about whole amounts here. I need a steady income and that’s the whole purpose of investing in debt isn’t it?

Good, even here mutual funds come with great benefits. Selecting the dividend option in debt schemes will generate a steady stream of ‘income’ for the investor. What about the taxation on this dividend? In the hands of the investor this dividend is completely tax-free. However, this doesn’t mean that there is no tax being paid. The tax needs to be paid by the mutual fund scheme, i.e. it is paid at source. This tax is known as the dividend distribution tax and is approx 13.5%. So if the scheme I’d invested in were to announce Rs 10,000/- as dividend, then Rs 1,350/- would go as tax and I’d receive Rs 8,650/-. This is still better than paying Rs 3,000/- as tax and having only Rs 7,000/- in hand when investing in a bond/ FD. Again I made a difference in my income just by prudent tax planning.

I hope you have understood now the tax benefits of investing in debt mutual funds. I’d be happy to hear your comments and clear your doubts.

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