Investment in mutual funds has always been a subject matter of discussion for the investors due to its perplexing nature and taxes involved. An equity fund is an open- or closed-ended fund that invests primarily in stocks, allowing investors to buy into the fund and, thus, buy a basket of stocks more easily than they could purchase the individual securities.

There are thousands of equity funds with each having unique characteristics. Equity funds, in general, pursue one of these three primary goals: Income, capital gains, or both. Some general equity funds include aggressive growth funds, small company funds, growth and income funds, index funds, etc.

As per Indian Income Tax Act, equity oriented fund (EO fund) refers to units of Unit Trust of India or a fund wherein investible funds invested by way of equity shares in domestic companies exceed 65%of the total proceeds of such fund and which has been set up under a scheme of a mutual fund specified under Section 10(23D) of the Act. The percentage of equity shareholding of the fund is computed with reference to the annual average of the monthly averages of the opening and closing amounts.

The gains/losses arising on the transfer of units of EO fund are classified as short-term/long-term capital gains depending upon their period of holding. If the period of holding of the unit of EO fund is more than 12 months, it is classified as long-term capital gain/loss. Where the period of holding is 12 months or less, it is classified as short-term capital gain/loss.

Long-term capital gain arising on transfer of units of EO fund is exempt from tax where such units are sold through a recognised stock exchange in India and such sale transaction is subject to Securities Transaction Tax (STT). However, any such long-term capital gains arising in the hands of a company shall be considered while computing book profits for the purpose of Minimum Alternate Tax (MAT).

In cases where the transfer of units of EO fund is not through a recognised stock exchange and STT has not been paid, the long-term capital gain is taxable at 20% on the amount of capital gain, subject to availability of indexation benefits, i.e., the capital gains shall be the difference between the sale consideration and the indexed cost of acquisition (the cost of purchase is increased by applying the cost-inflation index). However, one has an option to pay tax on long-term capital gain at 10%(without taking the indexation benefit) on transfer of units of EO fund.

This option of choosing between 20% on long-term capital gains post indexation and 10% of capital gains without indexation is available only in case of securities listed on any recognised stock exchange in India/units of mutual fund specified under Section 10(23D) of the Act or of the Unit Trust of India. Short-term capital gain is taxed at normal rates (i.e., the slab rates). However, in terms of Section 111A, short-term capital gain arising on transfer of units of EO fund (not held as stock in trade) is taxed at a flat rate of 15%. This is inter alia subject to the condition that such transaction is subject to STT.

When the total taxable income, excluding the short-term capital gain taxable under Section 111A and long-term capital gain, is less than basic exemption limit, the long-term capital gain or short-term capital gain is to be reduced to the extent of such shortfall while calculating the tax liability. Equity-oriented funds are not required to deduct any distribution tax on any dividend distributed to unit holders.

The writer is managing partner of Nangia & Co.