How Mutual fund Capital Loss tax credits work

About a year back, I wrote an article on mutual fund capital loss tax credit (please see our post, Mutual Fund Capital Loss: Tax Implications). Our target audience of this topic was primarily short term investors and traders. However, most of our readers are long term investors and for them this topic was of little relevance. Though there were rumors of long term capital gains tax on equity last year also, those came to naught and very frankly, I did not expect that, equity investors would have worry about long term capital gains tax in the near future. Sadly I was mistaken and long term capital gains tax is a reality now.

While there are multiple views on long term capital gains tax and the extent of its impact, the fact is that, any tax change has an impact on investors. My personal views on this are not important - long term capital gains tax is reality and the tax implications of Mutual Fund Capital Loss is now relevant for all investors, not just short term investors. Accordingly, we have updated our earlier post on this topic, so that investors understand how they can set off losses in some investments against profits in other investments. In this blog post, we will discuss tax implications of capital loss, for equity and debt funds.

Capital Gain or Loss is made only when you sell

From a tax perspective, you make a capital gain or loss only when you sell or redeem; if your fund has appreciated or depreciated in value, but you are still holding it, there is no capital gain or loss. You make a capital gain in a mutual fund scheme if the NAV of the scheme at the time of selling is more than the NAV of the scheme at the time of purchasing; you make a capital loss, if the NAV of the scheme at the time of selling is less then NAV of the scheme at the time of purchasing.

What are short term and long term capital gains?

For equity shares and mutual funds, sales / redemptions made within 12 months of the purchase will be give rise to an incidence of short term capital gains / loss. Sales / redemptions made after 12 months of the purchase will be treated as long term capital gains / loss. For debt mutual funds, sales / redemptions made within 36 months of the purchase will be give rise to an incidence of short term capital gains / loss. Sales / redemptions in debt funds made after 36 months of the purchase will be treated as long term capital gains / loss.

Setting off capital losses

The most important tax implication of a capital loss in a mutual fund scheme is that it can be set off against capital gains, depending on the nature of the loss. Let us understand this with the help of an example.

Let us assume that, you have bought two mutual fund schemes in the same financial year. Before the end of the financial year, you sold both the schemes. In one scheme you made a profit of Rs 50,000 and in another scheme you made a loss of Rs 10,000. In the scheme where you made a profit of Rs 50,000 you have to pay short term capital gains at the rate of 15% plus cess. Your capital gains tax obligation is, therefore Rs 7,500 plus cess.

What about the scheme were you made a loss? Obviously there is no tax, but under Income Tax Act 1961, you can set off the loss against the gain. You can show both the capital gain and loss in the Income from Other Source in your ITR and net off the loss from the profit. Therefore, your net short term capital gain will be Rs 40,000 (Rs 50,000 – Rs 10,000) and your tax obligation will be Rs 6,180 only. By setting off losses against gains, you are reducing your tax obligation. Readers should note that, not all capital losses can be set off against capital gains. There are tax rules governing capital loss setting off. Let us discuss each capital gain / loss case one by one.

Now with the re-introduction of long term capital gains tax for equity funds, you can also set off long term capital loss arising out of sales after April 1, 2018. Long term capital loss (investment holding period of more than 12 months)will be “allowed to be set-off and carried forward. Unabsorbed loss can be carried forward to subsequent eight years for set-off against long-term capital gains," clarified the Central Board of Direct Taxes (CBDT) through frequently asked questions (FAQs).

Short Term Capital Loss in Equity Funds

Short term capital losses from equity funds can be set off against short term capital gains from all asset types. These asset types can be another equity fund, debt funds, shares of companies, debenture, gold, real estate etc. The holding period definition for short term capital gains taxation differs from asset type to asset type. Short term capital gain / loss holding period for equity funds is 12 months, while that for debt funds is 36 months. So, if you have made a loss in an equity fund held for less than 12 months, you can set off the loss against profit made in a debt fund held for less than 3 years. The netting off applies against other asset types like shares, debentures, gold, real estate etc.

Short term capital losses in equity funds can also be set off against long term capital gains of asset types like debt funds, debentures, gold, real estate etc. As per Section 74 of Income Tax Act, short term capital losses can be set off against long term capital gains of all assets, including equity funds and shares. Since long term capital gains are tax free till 31^st March 2018, short term capital losses cannot be offset long term capital gains in equity funds or shares.

We are awaiting further clarifications from the Income Tax Department, on setting off short term capital losses against long term capital gains in equity funds and shares and update this post accordingly. When setting off short term capital losses in equity funds against long term capital gains of other asset types, do not subtract the capital loss from the gain because the tax rates are different for different asset types; calculate the tax payable on long term capital gains and the tax credit due to the capital loss. The difference between the tax payable and the tax credit is your tax obligation.

Let us assume you made a short term capital loss of Rs 20,000 in an equity fund. Ignoring cess (for the sake of simplicity), you can claim a tax credit of Rs 3,000 (Rs 20,000 X 15% STCG) to be set off against gains. Let us now assume you invested in Rs 100,000 in a debt fund 5 years back and your redemption value is Rs 150,000. Long term capital gains in debt funds are taxed at 20% after allowing for indexation benefits. The indexed cost of purchase will be Rs 100,000 X (Cost of inflation index in current year / Cost of inflation index in year of acquisition year) = 100,000 X (272/200) = Rs 136,000. Let us assume the redemption value of your debt fund is Rs 150,000. So your long term capital gain after indexation is Rs 14,000 and your long term capital gains tax will be Rs 14,000 X 20% = Rs 2,800. You can apply Rs 3,000 tax credit in the equity fund to your long term capital gains tax of Rs 2,800 in the debt fund. Thus you will not have to pay any tax.

Long Term Capital Loss in Equity Funds

In this budget, the finance minister, Mr. Arun Jaitley, proposed that long terms capital gains in equity shares and equity mutual funds above Rs 1 lakh be taxed 10% plus cess. This legislation will become effective on April 1, 2018. So, all long term capital gains realized in this financial year (FY 2017 – 18/ AY 2018 – 19) will continue to be tax free. Further, long term capital gains till January 31, 2018 will be grandfathered.

Some readers may be confused with the term grandfathering. Grandfathering from a legal perspective is exempting someone of something from a change in legislation up to a certain point in time, in this case all capital gains made till January 31, 2018 are tax exempt. For example, if you purchased a mutual fund scheme at a NAV of Rs 10 more than 12 months back and the NAV on January 31, 2018 was Rs 15. If you sell at a NAV of Rs 17 post April 1, then the long capital gains will be Rs 2 and long term capital gains will be Rs 0.20 plus cess.

What if you sold at a price below Rs 15, say Rs 13 after April 1? Can you claim a long term capital gains tax loss of Rs 2? The answer is no. The tax proposal for determination of acquisition cost for the purpose of long term capital gains tax is as follows:-

The cost of acquisition for the purposes of computing capital gains in respect of the long-term capital asset acquired by the assesses before the 1st day of February 2018, shall be deemed to be the higher of (i) the actual cost of acquisition of such asset and (ii) the lower of —

1. The fair market value of such asset (price as on Jan 31st 2018)


2. The full value of the consideration received or accruing as a result of the transfer of the capital asset

In this case, the actual cost of acquisition is lower than both the January 31, 2018 price and sale price. Therefore, the lower of January 31, 2018 price and sale price will be considered for long term capital gains. Since the grandfathered price (Jan 31, 2018 price) is higher than the selling price, there will be no long term capital gains tax.

Let us now take another example. Suppose you bought at a NAV of Rs 10. The January 31 price was Rs 8 and the selling price was 13. Since the grandfathered price is lower than selling price, we will compare this with purchase price with the grandfathered price. Since the purchase price is higher than grandfathered price, it will be considered as the cost acquisition and not the grandfathered price. So the long term capital gains in this case will be Rs 3.

Now let us discuss the example of a loss. If you sold your mutual fund at a NAV of Rs 8 (purchase price of Rs 10) and the grandfathered price (Jan 31 price) was Rs 15, you will be able to claim a long term capital gains loss of Rs 2. Please note that you will not be able to claim Grandfathered Price – Sale Price as loss, if the sale price is lower than purchase price. Therefore, if sale price is lower than purchase price, for investments held for more than 12 months, then the January 31 price is irrelevant.

Short Term Capital Loss in Debt Funds

Short term capital losses from debt funds can be set off against both short term and long term capital gains of all asset types. These asset types can be equity fund, debt funds, shares of companies, debenture, gold, real estate etc. So you if have made a loss in an debt fund held for less than 36 months, you can set off the loss against profit made in a equity fund held for less than a year. Short term capital losses from equity funds can also be set off against long term capital gains of all asset types.

Long Term Capital Loss in Debt Funds

Long term capital losses from debt funds can be set off against long term capital gains of all asset types, including equity funds and equity shares. Suppose you have made a long term capital loss of Rs 20,000 in a debt fund and a long term capital gains of Rs 50,000 in a Gold ETF. Let us assume that long term capital gains tax (@ 20.6% after indexation) for the Gold ETF is Rs 6,000. Further assume that tax credit for the debt fund loss is Rs 1,000. Therefore, your tax obligation will be Rs 5,000 plus cess.

Long term capital losses from debt funds cannot be set off against short term capital gains. For example, if you have made Rs 20,000 long term capital loss in a debt fund and Rs 20,000 short term capital gain in an equity fund. You will not be able to set off the loss and will have to pay 15% plus cess short term capital gains tax on the equity funds profit.

Conclusion

We devoted the major part of the blog post to equity funds because they are impacted in this year’s budget proposals. Long-term capital loss arising from sale or redemption in equity funds on or after April 1, 2018, will be allowed to be set-off and carried forward. It can be set-off against any other long-term capital gains and unabsorbed loss can be carried forward to subsequent eight years for set-off against long-term capital gains.

However, remember that since tax exemption is available on long-term capital gains on units sold till March 31, 2018, the long-term capital loss arising during this period will not be allowed to be set-off or carried forward.

In this blog post, we discussed how you can use mutual fund investment losses to reduce your capital gains tax obligation, by setting off your losses against capital gains or carry it forward to reduce your tax obligations with regards to future capital gains.