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Which mutual fund has lower tax - international funds at 20 percent vs domestic at 10 percent?


21 Sep 2022 - Contact Sayan Sircar
6 mins read

This article settles the question of which type of capital gain calculation is better - debt-type funds taxed at 20% with indexation vs equity-type at 10%.

Which mutual fund has lower tax - international funds at 20 percent vs domestic at 10 percent?

Disclaimer: Taxation is a dynamic concept and the content of this article is valid on the date of publication and any subsequent updates. Always consult a professional tax advisor before doing anything that leads to taxes being due.

Table of Contents

Taxation rules of shares and mutual funds

Capital gains are the profit from selling a capital asset like stocks or mutual funds. Capital gains are of two types depending on the holding period (see table A below):

  • Long-term capital gain: LTCG
  • Short-term capital gain: STCG

While talking about the LTCG for mutual funds, an interesting problem arises (see table A below):

  • equity-type funds (>65% Indian equity) are taxed at 10% on profits beyond ₹1 lakh when sold after a year
  • debt-type funds (i.e all other funds) are taxed at 20% on profits with indexation benefit when sold after three years

We will examine over the long term (i.e. 3 years or more), which leads to lower taxation. While we might be tempted to say that the 10% case has a lower tax, the indexation benefit of debt-type funds might lead to a different result even with a 20% tax rate.

Should you invest in international stocks and funds if they are taxed at higher rates?

The question comes from the fact that, apart from debt funds, international funds also have the same debt-type taxation rules.

Table A: Taxation of stocks and mutual funds

Type Portfolio Short-term capital gains | Taxation Long-term capital gains | Taxation
Shares, Equity MF or equity-oriented Hybrid MF >65% Indian equity <365 days | 15% + cess + surcharge >= 365 days | <1 lakh/year is tax free. Gains above 1 lakh are taxed at 10% + cess + surcharge
Debt or Hybrid funds (debt oriented) or International funds <65% Indian equity <3 years | Taxed at slab rate >=3 years | 20% + cess + surcharge on gains post indexation

where, Capital gains = (Selling price - Buying price) * Units sold

and

buying price post indexation = (Buying price) * (Cost Inflation index today / (Cost Inflation index at the time of purchase). We cover this calculation in considerable detail here: How to use the Cost Inflation index (CII): latest value and historical rates.

Note that for equity shares and equity mutual funds, any capital gains incurred before 31-Jan-2018 is not taxable. This is the so-called ‘grandfathering clause’.

We will ignore the impact of the ₹1 lakh tax benefit for equity LTCG by assuming that there are already other sell transactions that use up this benefit.

This post targets those decision-making cases where investors might be choosing an equity-type fund vs. a debt-type fund, which are similar in the portfolio but differ in taxation.

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Which is better 10% tax or 20% after indexation

To understand the difference between the two taxation rates, we need to understand one fundamental point:

Indexation = Return - Inflation

If your asset grows at an average of 10% while inflation is 7%, then the taxable return is 3% per year.

The formulas are:

Equity-type taxation = 10% * [ (1+Return) ^ Time - 1 ]

Debt-type taxation = 20% * [ (1+Return) ^ Time/(1+CII) ^ Time - 1 ]

After ten years, the tax will be:

  • equity calculation will be 10% on 10%/year profit
  • debt-type calculation will be 20% on a 3%/year profit

If we run the numbers,

  • tax on equity-type will be 10% * [(1+0.1)^10-1] = 15.94%
  • tax on debt-type will be 20% * [(1+0.1)^10/1+0.07)^10-1] = 6.37%

On a ₹1 lakh investment, the maturity values will be:

  • ₹2,43,437 under equity-type tax calculation
  • ₹2,53,004 under debt-type tax calculation
  • the difference is ₹9,567

We will now show sensitivities for this result for a ten-year holding period:

(click to open in a new tab)
20% with indexation vs 10% without for 10 year holding period

As the table shows, the gap at 7% inflation and 10% returns is ₹9,567 as calculated above.


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How does this tax calculation matter in the long term?

We show a different type of sensitivity table for real returns (fund returns less CII) vs. the holding period. This is important since real returns over long-term holding periods are expected to be very close to zero.

(click to open in a new tab)
20% with indexation vs 10% without for 10 year holding period for various real return values

As the table unambiguously shows, for longer-term holding periods at a portfolio level, it is better to have a 20% tax with indexation as the tax rule.

A caveat that applies here is that tax rules are dynamic and will change without warning. While taxation is an important criterion for choosing assets, it should be considered with other aspects like risk, return and liquidity. The most important criterion for planning for goals is the asset allocation of the portfolio and should be the first criterion when creating a portfolio: What should be the Asset Allocation for your goals?.

As India matures as an economy, both inflation and equity or debt returns will go down over time meaning that the relationship between real portfolio returns will stay the same.

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This post titled Which mutual fund has lower tax - international funds at 20 percent vs domestic at 10 percent? first appeared on 21 Sep 2022 at https://arthgyaan.com


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