Income earned from mutual funds falls under two heads: dividend and capital gain.

Given that the tax implications can have a significant impact on the return earned, it is necessary to understand the tax implications for both these heads of income.

1. Let's take income earned under the head of dividends first.

As per existing tax provisions, income from dividends is tax free in the hands of the investor. However, this is not to say that there is no tax levied at all.

On the contrary, there is a levy of 12.5 per cent of the dividend declared as distribution tax. This tax is paid out of the profits/reserves of the mutual fund scheme declaring the dividend.

Therefore, although you may not feel the impact of the tax, it is borne by you.

The application of the distribution tax in case of mutual funds is, however, not universal.

The dividend distribution tax has to be paid only in case of debt schemes of mutual funds. Equity schemes are exempt from tax.

So, if you were to receive Rs 100 as dividend from a debt mutual fund, it is equivalent to Rs 112.5 being paid out, the incremental Rs 12.5 having been paid to the government as distribution tax.

In case of equity funds, however, as mentioned, there will be no such implication.

Investors who fall in the highest tax bracket should opt for the dividend option in mutual fund schemes.

But they should consider the fact that the tax on dividend paid to them has been paid by the mutual fund company itself in so far as debt schemes are concerned.

2. Let's now consider the second head of income from mutual funds: capital gain.

Capital gains from mutual funds are of two types: short-term and long-term.

This classification is based upon the period of holding. If the investment is sold within 365 days from the date of purchase, any capital gain made would be treated as a short term nature.

Such a capital gain will be treated as a part of the total income and chargeable to tax at the normal rate of tax.

If the mutual fund investment is sold after 365 days from the date of purchase, any capital gain made during that period will be treated as a long-term capital gain.

Tax on long term capital gains is computed as follows:

Step I: Compute Capital gains with indexation

Sale Proceeds                                          xxx
Less: Indexed Cost of Acquisition                xxx
                                                                ----
Long-term Capital Gains                       xxx
                                                                ----

Tax payable will be 20 per cent of capital gains as computed above.

Formula for calculation of indexed cost of acquisition:

Cost of acquisition / Cost inflation index for the year in which asset is acquired  x Cost inflation index for the year in which asset is transferred.

Step II: Compute Capital Gains without indexation

Sale Proceeds                                          xxx
Less: Cost of Acquisition                             xxx
                                                                ----
Long-term Capital Gains                       xxx
                                                                ----

Tax payable will be 10 per cent of capital gains as computed above

Compare the tax payable under both the options. Lower of the two will be tax payable.

Example: Mr A purchased 5,000 units of a mutual fund on 20-6-1999. The price per unit is Rs 10. He sells all the 5,000 units on 15-9-2000 for Rs 12 per unit.

Since the investment is held for more than 365 days the capital gain will be long-term capital gain.

The capital gains will be calculated as follows:

Step I: Compute Capital gains with indexation

Sale Proceeds        (5,000 units x Rs 12 )      =       60,000
Less: Indexed Cost of Acquisition**             =         52,185
                                                                           ------------
Long-term Capital Gains                            =         7,815
                                                                           ------------

Tax payable will be 20 per cent of Rs 7,815, i.e. Rs 1,563.

** Indexed cost of acquisition: 50,000 x 406 / 389 = Rs 52,185

Step II: Compute Capital Gains without indexation

Sale Proceeds        (5,000 units x Rs 12)                  =    60,000
Less: Cost of Acquisition  (5,000 units x Rs 10)       =       50,000
                                                                                    -----------
Long-term Capital Gains                                      =      10,000
                                                                                     ---------

Tax payable will be 10 per cent of Rs 10,000 i.e. Rs 1,000.

Compare the tax payable under both the steps. Lower of the two will be tax payable. Therefore, the tax payable will be Rs 1,000.

Tax liability on mutual fund investment can be reduced either by choosing the dividend option or by holding the investment for more than 365 days.

Set off and carry forward of capital gains:

• Long-term capital loss can be set off only against long-term capital gains. Short-term capital can be set off against any capital gains, whether short-term or long-term.
• Long-term capital loss can be carried forward for eight years to be set off only against long-term gains.
• However, a short-term capital loss can be set off against any income under the head "capital gains" (whether short-term or long-term) and such carry forward is permitted for eight years.