For NRIs, a cost-effective way to participate in the Indian equity market is investing in mutual funds (MFs) as they offer a mix of return, tax efficiency and liquidity. All investments made by NRIs in India have to be in rupee. To invest in MFs, an NRI has to open one of the three bank accounts — a non-resident external rupee (NRE) account, non-resident ordinary rupee (NRO) account or foreign currency non-resident account (FCNR) — with an Indian bank.
Taxability of income
The basic tax rates for investments in MFs are the same, whether you are an NRI or an ordinary Indian citizen. There are essentially two kinds of incomes that NRI investors would earn from MFs — dividends and capital gains. Capital gains are further segregated into short-term and long-term gains. Taxation differs as per the kind of income.
Dividends from MFs are completely tax-free in the hands of the investor as per Section 10(35) of the Income Tax Act. However, there is a distribution tax payable by the MF directly to the exchequer.
As far as capital redemption is concerned, if MF units are held for more than 12 months, the same would qualify as long-term capital assets. Else, these would be termed as short-term capital assets.
The taxation of capital gains differs for equity oriented-schemes and non-equity schemes. For equity-oriented schemes, long-term capital gains (LTCG) are tax-free whereas short-term capital gains (STCG) tax is payable at a flat rate of 15%. For MF units that are non-equity oriented, LTCG tax is payable @10% without indexation or @20% with indexation, whichever is lower, and STCG are taxed at the normal rates applicable to the investor.
TDS on mutual funds
MFs are not required to deduct tax at source for resident taxpayers. However, the exemption from TDS which resident Indians enjoy is not available for NRIs. The idea behind TDS on MF withdrawals is that it could get difficult for income-tax authorities to chase NRIs if they fail to file their tax returns.
MFs are supposed to charge TDS at the highest rate applicable, even though the tax rate liability is less. Hence, there may be a difference between the applicable tax rate for an NRI and the TDS rate charged by the MF.
Since dividends from units are tax-free for the investor, there is no question of TDS. However, capital gains are subject to TDS. Since the LTCG on equity oriented schemes is nil, there is no TDS either. The TDS on STCG from equity oriented schemes is @15%. On other schemes, TDS on LTCG is @20% and on short-term gains is @30%.
Course of action
The TDS is a flat rate. However, if you fall in a lower tax bracket, you are entitled to a refund. For instance, if you withdraw from your debt fund within a year, TDS of 30% gets deducted. But if you fall in, say, the 20% tax bracket, or if your income is below the taxable limit, you are entitled to a refund. Also, units of non-equity oriented schemes are taxed at 10% without indexation or 20% with indexation, whichever is lower, but the MF will deduct TDS at a flat 20% for NRIs. Ensure you file your return in India to claim refund of additional taxes withheld by the MF.
By Rakesh Nangia
The writer is managing partner, Nangia & Co. With inputs from Neha Malhotra, Nangia & Co