Ever since their launched in India in 2002, Exchange Traded Funds or ETF have evolved as a majorly popular investment avenue. It is a basket of securities/equities that usually tracks an underlying index and follows the passive investment methodology. The fund manager doesn’t attempt to beat the market but replicate the returns offered by the index. However, before you invest in any instrument, it is principal to understand the tax liability arising from income or gains generated by your investment. Now, we will talk about the taxation laws adjoining ETFs in India.
The Modern Rules Of Avenues To Earn Money Using ETFs.
Before we start watching the taxation rules surrounding ETFs, let’s check out the various ways during which you’ll earn money using them.
An ETF or an Exchange Traded Fund may be an open-end fund that follows the passive investment strategy and tracks an underlying index. It is often traded within the secondary market of a stock market like shares at a price determined by the demand and provides within the market. ETFs are of various categories supported by the securities they invest in. These are:
• Equity ETFs – that track a stock market index and invest in equities or equity-related instruments
• Debt ETFs – that-one track bonds and invest in fixed income securities
• Gold ETFs – that track the particular price of gold and invest in gold
• International ETFs – that track stock exchange indices from different countries round the globe
Each of those ETF types has different tax treatments. But, how do investors make money by investing in ETFs?
There are two to earn money using ETFs:
I. Dividend Income
II. Capital Gains
1. Dividend Income
An ETF maybe a basket of securities. Hence, the dividend that you simply can earn by investing independently with each security also will be applicable to an ETF. for instance, if you invest in an Equity ETF that features a portfolio of say 50 shares, then the fund will receive a dividend from each of these 50 companies. Some fund houses will expire the dividends to the investors while others might reinvest the quantity into the ETF and offer higher total returns. These dividends are subject to tax.
2. Capital Gains
Investors can trade the units of an ETF within the secondary market of a stock market. This market is where shares are bought and sold and therefore the prices of shares are determined by investor sentiment and the demand and provide of a stock. Since an ETF invests during a basket of securities, the over/underperformance of 1 security from its basket of securities doesn’t impact its unit price tons. However, if the market tracked by the ETF suffers, then the worth of the ETF can fall and the other way around. for instance, this year, the Nifty Pharma index that tracks the performance of some key companies within the pharmaceutical sector in India, experienced growth despite most of the opposite sectors failing to perform thanks to the pandemic. Hence, investors who had bought an ETF that tracks the Nifty Pharma would have benefited from this movement. once you sell units of the ETF for a profit, the gains arising are defined as capital gains and taxed as per the character of the securities held by the ETF.
Tax on ETFs in India
Let’s check out the taxation rules for both dividends and capital gains in India:
1. Tax on ETF Dividends
Until last year, dividend income was taxable within the hands of the corporate or the open-end fund . A dividend distribution tax or DDT of 15% was levied on all dividends paid to investors. From the fiscal year 2020-21, the DDT has been abolished and therefore the dividend income is added to the annual income of the investor, and tax is deducted as per the applicable tax slab rates. While companies and mutual funds are susceptible to withhold tax at the speed of 10% for dividends paid to individuals within the more than Rs.5000, this has been relaxed to 7.5% until March 2021 considering the pandemic.
For non-resident investors (NRIs), domestic companies and Mutual Funds are required to withhold tax at the speed of 20%. If the NRI lives in a country where the provisions of the Double minimization Agreement (DTAA) apply, then tax computation and withholding are going to be done as per the restricted tax rates.
2. Tax on Capital Gains made up of ETFs
Since long-term & short-term capital gains are defined as supported the sort of securities, let’s check out the tax treatment for ETFs for every category:
Tax treatment for principal/capital gains earned from Equity ETFs
An equity ETF invests in equities or equity-linked instruments. Hence, the tax treatment of capital gains made up of these ETFs is analogous thereto of individual shares. Therefore, the definitions of long-term and short-term capital gains are as follows:
• Long-Term financial gain (LTCG) – this is often any gain arising from the sale of the units of an equity exchange-traded fund that was held for quite 12 months.
• Short-Term financial come by the gain (STCG) – These are often any gain arising from the sale of the units of an equity exchange-traded fund that was held for fewer than 12 months.
The tax rates are as follows:
• LTCG – Not tax on the capital gains up to Rs.100000. Any LTCG in more than Rs.1 lakh are going to be taxed at 10% without indexation benefits (Section 112A of the tax Act, 1961)
• STCG – As per Section 111A of the tax Act, 1961, STCG is taxed at 15% plus surcharge and applicable cess.
Tax for capital gains earned from Debt ETFs, Gold ETFs, and International ETFs
While the tax on capital gains is different for equity investments, capital gains from debt, gold, and international ETFs are taxed within the same manner. Long-term & short-term capital gains for these ETF’s are described as follows:
• Long-Term financial gain (LTCG) – this is often any gain arising from the sale of the units of an equity exchange-traded fund that was held for quite 36 months.
• Short-Term Capital gain (STCG) – Often any gain arising from the sale of the equity units of an equity exchange-traded fund that was held for fewer than 36 months.
The tax rates are as follows:
• LTCG – LTCG from debt, gold, or international ETFs are going to be taxed at 20% with indexation benefits
• STCG – Any STCG from debt, gold, or international ETFs are going to be added to the investors’ annual income and taxed as per the applicable tax slab rates
Reduce liabilities by Setting Off Capital Losses Arising from the Sale of an ETF
When you sell units of an ETF, there are often times once you need to book losses rather than profits. These capital losses are often set-off against capital gains to scale back liabilities. However, there are some rules surrounding it as explained below:
• Principal / Capital Losses can ONLY be set-off against capital gains
• If you book a long-term financial loss, then you’ll set it off against long-term capital gains made during that year
• If you book a short-term financial loss, then you’ll set it off against both short-term and long-term capital gains made during the year
• If you’ve got not made enough capital gains within the same year, then the tax Department allows you to carry-forward both long-term and short-term financial loss es for eight assessment years instantly following the year where the capital loss was incurred
Summing Up
ETF’s have evolved as a preferred investment direction in recent years. While they provide the diversification of an open-end fund, they also bring the liquidity and simple trade offered by a share. Thus, many investors are adding ETF’s to their investment portfolios. With tax treatment being almost like mutual funds, ETFs are excellent passive investment instruments. I hope this article helped you gain clarity about ETFs taxation in India.
Thank you, Learners!
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