Despite its crucial importance, high visibility and spectacular rise, the Mutual Fund (MF) as an investment instrument is the least understood and most misunderstood, particularly by retail investors. Thankfully, the government, SEBI as well as MFs themselves have been earmarking a sizable fund for Investor Education Programmes but so far this appears to have had limited impact.

Economists, all over the world, recognise the retail investor as the main artery supplying blood to the heart of the economy of a nation. It is necessary to try and impart to the retail investor much-needed insight into the system, in an endeavour to help him pocket benefit therefrom.

This week’s article provides readers with a handshake acquaintance with the MF as an investment instrument and also familiarises one with the latest taxation amendments that have been carried out in this space.

Raison d’etre

All MFs have the twin objectives of mobilising the savings of the masses

  1. i) Channelise them into productive corporate investments and
  2. ii) Provide facilities to persons of even modest means of owning indirectly, equity shares, including exchange-traded funds, corporate bonds, debentures and government securities. So an MF is nothing but a financial intermediary between the investors and markets (stock and debt). It protects the investor against capital risk by giving him the benefit of its professional expertise in investment management. The MF’s constant supervision on the portfolio, which it holds on behalf of the investor and the diversification of large funds over an extensive portfolio throughout the spectrum of industries, is of great value.


MFs schemes are extremely flexible and provide various functionalities to the investor ––

  1. Savings Bank Account: Deposit and withdraw whenever you feel like.
  2. Systematic Withdrawal Plan (SWP) = Pension: You can give standing instructions to receive some amount of your choice at a periodicity of your choice — annual, six monthly, quarterly or even monthly!
  3. Systematic Investment Plan (SIP): You can invest some fixed amount at regular intervals (monthly/quarterly) until you cancel the facility.
  4. Emergency Management: No need to keep a large amount liquid for unforeseen calamities.

Latest changes in this space

  1. Debt-based schemes of MFs were treated on par with equity-based schemes. The holding period of over 1 year qualified them to benefits of long-term capital gains. This holding period has now been increased to the normal 3 years applicable to real estate and other such assets.

The option of long-term capital gains tax @10.3% without indexation is no more available to debt-based schemes. The tax applicable will be the flat rate of 20.6%. This does not hurt much because on finer analysis 20.6% was mostly, a better option.

For instance, suppose you have invested Rs1,00,000 in FMP having a term of 370 days (just over one year) in FY 13-14 when the index is 939 and the scheme got redeemed in FY 14-15 when the index is 1,024. Assume that the FMP grew by 9% and therefore the redemption value received is ` 1,09,000. In that case, the indexed cost works out at Rs 1,08,733 (= 1,00,000 × (1,024 / 939)).

LTCG =  Rs  267 (= 1,09,000 – 1,08,733). Tax @20.6% =  Rs 55.

Profit = Rs 9,000 (= 1,09,000 – 1,00,000). Tax @10.3% = Rs 900.

Obviously, the option of 20% with indexation works out to be better.

Note: Dates of earlier years have been taken for convenience.

  1. The MFs played a neat trick to pocket the benefit of double indexation. How was this done? Let us take the same example.

 Assume that the FMP was launched on 29.3.13, i.e. FY 12-13 and the term being 370 days, date of maturity was 3.4.14, i.e. FY 14-15. Index in FY 12-13 is 852. Substituting these figures in this example, we arrive at a long-term loss of Rs 20,188!

This loss can be set off against any other taxable capital gain during the year and if this is not possible, it can be carried forward for set off in future for 8 successive years. Double indexation is no more possible.

This also does not hurt much. It is a fact that in the case of debt based MFs, longer the holding period, better is the benefit, thanks to indexation. We can take advantage of even quadruple indexation. To get convinced, let us take an example.

The maturity value of  Rs 1,00,000 at the end of 3 years @ 9% p.a., is 1,29,503 (= 1,00,000 x 1.093). FMP was launched on 29.3.11, i.e. FY 10-11 and the term being 3 years and 5 days, date of maturity was 2.4.14, i.e. FY 14-15 (2012 was a leap year). Index in FY 10-11 is 711. The indexed cost works out at Rs 1,44,023 (= 1,00,000 x 1,024/711). Consequently, the LTCG is a loss of Rs 14,520!!

Bank FD offering 9% p.a. interest rate, would have forced the investor to pay tax of Rs 927 or Rs 1,851 or Rs 2,781 depending upon his tax zone (10, 20 or 30 per cent). And this tax has got to be paid every year, even on cumulative FDs. There are no ‘Growth’ FDs with banks unlike Growth schemes of MFs.

  1. Now comes the worst injury. A flat rate of 25.75% was applicable on dividends paid by all debt-based schemes, including FMPs. FA14 applied a surcharge of 10% taking the rate at 28.325% and the recent FA15 raised it to 12% taking the rate at 28.84%.

To Sum

The following is a snapshot of how investors must structure and strategize their investments:

1.Those who have risk appetite, choose equity-based dividend paying schemes. The dividends do not suffer DDT and are truly tax-free in the hands of the investors.

  1. Others should choose growth-schemes of debt-based schemes. Realise that dividend-paying schemes suffer double taxation — Once when companies pay dividends to MFs and again when the MFs pay dividend to unitholders. Moreover, there is the draconian DDT to be taken care of.
  2. If the horizon of investment in a debt based fund is less than three years, choose the dividend option.

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