Taxation on Thematic Funds: A Simple Guide for Investors

As per Section 112A of the Income Tax Act, 1961, an equity-oriented mutual fund is a scheme that invests a minimum of 65% per cent of its total proceeds in equity shares of domestic companies listed on a recognised stock exchange.

Now, since a thematic fund satisfies SEBI’s minimum investment requirement of 80% in equity and equity related instruments, it automatically meets the Income-tax test for being an equity-oriented mutual fund. That is why thematic funds are taxed under the equity scheme rules.

When you redeem or sell units of a thematic mutual fund, any profit earned is treated as a “capital gain” under the Income-tax Act, 1961. The nature of this capital gain depends entirely on how long you held those units before redemption, known as the “holding period”. The classification is made as follows:

Now, based on this distinction, the correct capital gain tax rate is determined.

When you sell units of a thematic mutual fund after holding them for more than 12 months, the profit you earn is treated as a LTCG. However, the tax rate on LTCG has undergone a major revision through the Finance Act, 2024, effective from 23 July 2024. 

Section 112A of the Income-tax Act, 1961 now prescribes two distinct mutual fund tax rates depending on when the transfer (sale/redemption) takes place. Let’s understand in detail:

Some Important Points to Remember

• Only the portion of LTCG exceeding ₹1,25,000 (earlier ₹1,00,000) in a financial year is taxable. 

• This exemption applies across all equity-oriented holdings combined (shares + ETFs + mutual funds).

A Hypothetical Example

Suppose you invest ₹5,00,000 in a thematic fund in April 2023 and redeem it in August 2024 for ₹7,50,000. Now, since your holding period is more than 12 months, your profit of ₹2,50,000 (₹7,50,000 - ₹5,00,000) will be taxed as LTCG. 

Additionally, because you redeemed the units after July 2024, the tax rate of 12.5% applies. In the instant case, capital gain tax for the aforesaid investment in mutual fund will be calculated as follows:

So, your final tax payable will be ₹15,625 (plus applicable surcharge and cess).

STCG arises when you sell your units of a thematic fund within 12 months of purchase. The Finance Act, 2024 has introduced a higher tax rate for STCG effective from 23 July 2024, increasing it from 15% to 20%. The applicable tax rate will once again depend on the date on which you transfer or redeem your investment. Let’s see how:
 

A Hypothetical Example

Suppose you invest ₹5,00,000 in a thematic fund in March 2024 and redeem it in August 2024 for ₹6,00,000. Now, since your holding period is 5 months, the profit of ₹1,00,000 (₹6,00,000 - ₹5,00,000) will be taxed as STCG. Also, because the transfer took place after July 2024, the STCG rate of 20% will apply. In the instant case, capital gain tax for the aforesaid investment in a mutual fund will be calculated as follows:

So, your final tax payable will be ₹20,000 (plus applicable surcharge and cess). Remember, if the redemption or transfer had taken place before 23rd July 2024, the applicable tax rate would have been 15%, making the STCG tax of ₹15,000 (plus cess) instead.

Taxation of Mutual Funds: What Every Investor Needs to Know - STCG, LTCG, Dividend Income and ELSS

Since FY 2020-21, dividends paid by mutual funds are taxable in the hands of the investors [post-abolition of Dividend Distribution Tax (DDT)]. Now, to pay tax on mutual fund earnings, unit-holders must:

• Declare dividend income under ‘Income from Other Sources’ and

• Charge taxes as per their applicable slab rates and claim a credit of taxes withheld by the mutual fund on income distributed by the mutual fund to the investors as dividend income.

   

Till now, you must have understood that thematic funds are taxed as equity-oriented mutual funds under the Income-tax Act, 1961. Based on your holding period, your gains can either be long-term (if held for 12 months or more) or short-term (if held for less than 12 months).

Next, LTCG up to ₹1,25,000 is exempt, and only the amount exceeding that limit is taxable. The applicable rates are 10% for transfers before 23rd July 2024 and 12.5% for transfers on or after 23rd July 2024. In contrast, STCGs are taxed at 15% for transfers before 23rd July 2024 and 20% for transfers on or after that date.

Lastly, remember that dividends distributed by mutual funds are now fully taxable in your hands under the head “Income from Other Sources.” Such dividend income will be taxed as per your applicable income tax slab rates and must be disclosed while filing your Income Tax Return (ITR).

The views mentioned above are for information & educational purposes only and do not construe to be any investment, legal, or taxation advice. Investors must do their own research before investing. The views expressed in this article are personal in nature and in is no way trying to predict the markets or to time them. Any action taken by you on the basis of the information contained herein is your responsibility alone, and Tata Asset Management Pvt. Ltd. will not be liable in any manner for the consequences of such action taken by you. Please consult your Mutual Fund Distributor before investing. The views expressed in this article may not reflect in the scheme portfolios of Tata Mutual Fund. There are no guaranteed or assured returns under any of the schemes of Tata Mutual Fund.