Diversification is vital for your portfolio. You can manage your risk better and earn steady gains by investing in various asset classes and investment tools. You can also derive tax benefits by investing in certain assets, thereby saving money. This article covers Exchange-Traded Funds (ETFs) and how they are taxed in India.
What is an ETF mutual fund?
Exchange-Traded Funds (ETFs) track an underlying index and are traded on stock exchanges. For instance, there could be an ETF tracking the performance of the Indian IT index and yield returns depending on the performance of the IT index.
ETFs are generally of three types:
- Equity ETFs that track sectoral equity indices
- Gold ETFs
- Debt ETFs
How are ETFs taxed?
ETF tax is levied on two categories of taxable income – income generated through dividends and income earned through capital gains. While these categories remain the same, different ETF types are taxed differently. In this section, we will understand the taxation of ETFs based on their types.
- Dividend Distribution Tax
Before the Financial Year (FY) 2020-2021, a Dividend Distribution Tax was applicable on income earned through dividends on an ETF investment. The concept of dividends was abolished in the same financial year, and income dividends since then are added to the investor’s annual income.
- Mutual funds were liable to withhold a tax of 10% for all dividends paid to investors before the pandemic, a rate that was reduced to 7.5% after March 2021.
- For Non-Resident Indians (NRIs), the Dividend Distribution Tax was 20%. If the NRI resides in a country where the Double Tax Avoidance Agreement (DTAA) provisions apply, the tax structures are applicable as per the law.
- Income earned through capital gains
The taxation of income earned through capital gains is different for equity ETFs and non-equity ETFs.
- Tax on capital gains for Equity ETFs
- The capital gains from selling equity ETFs held for less than a year are termed Short-term Capital Gains (STCG). Section 111A of the Income Tax Act states that short-term capital gains are taxed at 15%, along with surcharge and other applicable taxes.
- The capital gains from selling equity ETFs held for longer than a year are called Long-term Capital Gains (LTCG). As per Section 112 A of the Income Tax Act, up to ₹1 lakh is deductible for all long-term capital gains, and a tax of 10% is levied on any amount greater than ₹1 lakh without indexation benefits.
- Tax on capital gains for gold, debt, and other ETFs
The definition of long- and short-term capital gains changes a little in the context of non-equity ETFs.
- The capital gains from selling non-equity ETFs held for less than three years are termed Short-term Capital Gains. The amount earned through these gains is added to the investor’s annual income and taxed as per the applicable income tax slab rates.
- The capital gains from selling non-equity ETFs held for longer than three years are called Long-term Capital Gains and are taxed at 20% along with indexation benefits.
In conclusion, the taxation structure of ETFs in India is divided into two categories – ETF tax on income earned through dividends and ETF tax on capital gains. It is essential to understand both forms thoroughly to make wise investment decisions in ETFs.
