c-Market is flooded with innumerable investment options ranging from Fixed Deposits, Mutual Funds, Bonds, Stocks, Provident Fund, Pension Scheme, Real Estate, etc.

As an investor, our goal should be to focus on net real returns. Here “net” represents after adjusting for taxation and “real” signifies adjusted for inflation. In this article, we are going to talk only about “net”.

To understand “net”, we have to understand taxation for all the common investment products available in the market. Taxation of these products can be different at three different stages:

1. Investment or Contribution stage

2. Income Earning Stage

3. Withdrawal stage

We will start with the most basic investment vehicle, Fixed Deposits.

Fixed Deposits:

Interest income from Fixed Deposits is fully taxable and gets taxed at slab rates applicable to the FD Holder. It is advisable to treat interest income on accrual basis, specially when amounts are significant, and bank has deducted the TDS on accrued interest. When amounts are small such that bank has not deducted TDS, one can add the interest income at the time of maturity.

Premature liquidation of Fixed Deposit is possible, but it is noteworthy that interest on the deposit for the period that it has remained with the bank will be paid at the rate applicable to the period for which the deposit remained with the bank and not at the contracted rate.

Loan/overdraft against fixed deposit is possible.

Deduction under section 80TTB can be claimed by senior citizens (aged > 60 years) which provides a deduction of INR 50,000 or actual interest income earned through savings accounts and fixed deposits, whichever is lower.

Each depositor in a bank is insured up to a maximum of INR 5,00,000 (Rupees Five Lakhs only) for both principal and interest amount as on the date of liquidation/cancellation of bank's licence or the date on which the scheme of amalgamation/merger/reconstruction comes into force. All commercial banks including branches of foreign banks functioning in India, local area banks and regional rural banks are insured by the DICGC (Deposit Insurance and Credit Guarantee Corporation). At present all co-operative banks are covered by the DICGC.

Corporate Fixed Deposit

These are taxed exactly as Bank Fixed Deposits. But, these are not covered by DICGC. Deductions are not possible, under section 80TTB, for interest income earned on corporate fixed deposits. Pre-mature liquidation is possible, generally the terms are unfavourable when compared to Bank FD Loan against Corporate FD is possible. Minimum investment and minimum tenure are generally higher than bank fixed deposit. These deposits are rated by credit rating agency.

Non-Convertible Debentures (NCD)

For NCD holder, there can be either, interest income or capital gains or both. Capital gains can be short term for t < 1 year or long term for t > 1 year.

Interest earned on NCD is taxed like any interest income from Fixed Deposit i.e. at the slab rate of NCD holder.

Capital gain for holding period less than 1 year is also at slab rate of the NCD holder.

Capital gains for holding period greater than 1 years is at 10%.

NCDs provide the option to the investor to choose the frequency of interest payments either monthly, quarterly, half-yearly or annually. Some NCDs also offer an option of receiving interest on a cumulative basis i.e. investors do not receive any coupon during the tenure of the debenture instead received a lump sum amount on maturity.

A noteworthy point here is that cumulative option of NCD, are often mis-sold on the pretext that maturity proceeds will be taxable as capital gains. But, cumulative option of NCD must be taxed as interest income and not capital gains.

One more noteworthy point, TDS is not applicable on listed NCDs and TDS is mandatory for unlisted NCDs.

Tax free Bonds

As the name suggests, the most attractive feature of a tax-free bonds is its absolute tax exemption on the coupons as per Section 10 of the Income Tax Act of India, 1961.

As per Section 10(15)(iv)(h) interest on notified bonds issued by Public Sector Companies are exempt from taxes.

Don’t get impressed with the section, I have copied it.

What if someone wants to sell these bonds before maturity?

These bonds are long dated and are highly interest rate sensitive. Value of these bonds also depend on tax rates notified by the government. Higher the tax slabs, higher will be the value and vice versa.

Investors who subscribed to the primary issue in 2014,2015,2016 are sitting on a decent capital gains as yields have fallen drastically and also because of introduction of super rich surcharge (37%) for assesses with taxable income higher than 5 Crore. These bonds are listed on stock exchanges and investors have the option to sell them (most of the trades are OTC trades and are only reported to exchanges).

Taxation for these investors is based on holding period. If t > 1-year, Long-term Capital Gains at 10% and if t < 1-year, short-term capital gains which are taxed at slab rate of the investor.

Senior Citizen Savings Scheme

Interest shall be payable on quarterly basis. Interest is taxable on slab rate.

Post Office Monthly Income Scheme Account (MIS)

Interest is payable monthly and is taxed at slab rate.

Public Provident Fund / Sukanya Samridhi

Both these schemes have EEE status. At investment stage, investments are tax deductible under overall cap of 1.5 lakh. Interest earned is also tax free and maturity proceeds are also free from taxes.

Employee Provident Fund:

This scheme has EEE Status, subject to:

1. Contributions from employee from are tax deductible under section 80C up to overall limit of INR 1.5 lakhs & contribution made by the employer to the employees’ provident fund account accustomed to be totally free of taxes in the hands of the employee without any absolute rupee amount limit provided the contribution does not exceed 12% of the basic salary. However, the Finance Act, 2020 has spoiled the party and modified the rule to put absolute rupee cap of INR 7.50 lakh on the aggregate of contributions made by the employer to recognised provident fund (including employers provident fund), National Pension Scheme and any approved superannuation fund taken collectively in a financial year. In case the employer contribution in recognised provident fund (including employers provident fund), National Pension Scheme and any approved superannuation fund goes above INR 7.50 lakh, even the interest income on that incremental contribution is taxable.

2. Interest Income on contributions from employee (statutory and voluntary) are totally tax free at the moment but the recent googly in the Budget 2021 will make the interest income taxable for contributions greater than limit of INR 2.5 lakh per financial year. This is effective from 01st April’2021.

3. Withdrawal proceeds are completely tax free provided the withdrawals are made after 5 years of continuous service. (Even if in different organizations).

National Pension Scheme (Tier I Account)

This line will look controversial, but NPS also has EEE status:

In the contribution stage, three sections are applicable:

Section 80CCD(1)

Contribution made by Government Sector Subscriber (salaried), Non-Government Sector Subscriber (Private Sector Employees and Self-Employed persons). All these contributions come in overall cap of INR 1.5 Lakh

Section 80CCD(1B)

Additional deduction of INR 50,000 over and above Section 80CCD(1)

Section 80CCD(2)

For Contribution made by Employers (Government Sector Subscribers as well as Non-Government Sector Subscribers) for their employees. effective 01st April’2021, the employer's contribution in excess of INR 7.50 lakh towards Provident Fund, Superannuation Fund and NPS will be treated as perquisite and will be added to salary of the subscriber and taxed at slab rate. Moreover, interest and other income relatable to this excess contribution will be added to his income year after year.

Taxation on Returns Stage

Returns in NPS are captured by the movement in NAV. The taxation on this change in valuation is zero or we can say exempted.

Taxation at withdrawal stage

On maturity i.e. when the subscriber turns 60, withdrawal can be made but there is a caveat. 40% of the corpus has to be mandatorily invested in an annuity. Subscriber can choose the type of annuity and annuity service provider. Remaining 60% can be taken as lumpsum, no question asked, use it the way you like it. In case the accumulated corpus is less than or equal to Rs. 2 Lakh at the time of Superannuation or attaining age of 60 years, it can be withdrawn fully as lumpsum, no need for annuity. So, withdrawal is also tax free, but 40% has to be invested in annuity and pension income from annuity will be taxable at slab rate.

You can read more about NPS in my twitter thread here.

Unit Linked Insurance Scheme

For ULIPs purchased before 1st April 2012

The deduction under section 80C can be availed when the premium is less than 20% of the sum assured. Meaning Sum Insured should be at least 5X of the premium paid.

If the premium is more than 20% of the sum assured the tax deduction is allowed on the amount equal to 20% of the sum assured. In simple words, if Sum Insured is less than 5X of premium paid, deduction is available only to that quantum of premium where sum insured is 5X of deduction amount.

If the investor surrenders the policy before the completion of 5 years, or within the lock-in period, the tax benefit is reversed.

Under Section 10(10D), if the premium paid on the policy is less than 20% of the sum assured during the term of the policy the amount received on maturity are exempt from tax. Meaning, maturity proceeds are tax free if sum insured is at least 5 times the annual premium. But if the sum insured multiples is less than 5, the entire maturity proceeds become taxable at slab rate.

For ULIPs purchased after 1st April 2012 but before 01st Feburary’2021

The income tax deduction under section 80C can be availed when the premium is less than 10% of the sum assured. Meaning Sum Insured should be at least 10X of the premium paid.

If the premium is more than 10% of the sum assured the tax deduction is allowed on the amount equal to 10% of the sum assured. Simply means, if Sum Insured is less than 10X of premium paid, deduction is available only to that quantum of premium where sum insured is 10X of deduction amount.

If the investor surrenders the policy before the completion of 5 years, or within the lock-in period, the tax benefit is reversed.

Under Section 10(10D), if the premium paid on the policy is less than 10% of the sum assured during the term of the policy the amount received on maturity are exempt from tax. Meaning, maturity proceeds are tax free if sum insured is at least 10 times the annual premium. But if the sum insured multiples is less than 10, the entire maturity proceeds become taxable at slab rate.

For ULIPs purchased after 1st Feb’2021

Finance Bill 2021-22 has proposed to remove disparity between ULIPs when compared to mutual funds. If the premium is more than Rs. 2.5 lakh per year (applies to sum of the premium for all the ULIPs purchased on or after 01st Febueaey’2021) the maturity proceeds will be taxed identically to mutual funds. 

I am not sure, but, as policy holder can change the asset allocation in ULIP, how will it be determined whether to tax the gains as equity oriented mutual funds or non-equity-oriented mutual funds. Taxation of mutual funds is covered, keep reading.

Please note, death benefits will continue to remain tax-free, irrespective of the premium amount. 

Shares (Listed on recognized stock exchange)

Shares, can give income in two forms, periodic dividend income and capital gains when the investor sells the stocks. As Dividend Distribution Tax has now been abolished, dividend income is now taxed at slab rate of the investor.

This rule has not gone well with promoters of the company and HNIs as effective tax rate for them is as high as 42.74% (30% slab rate + 37% surcharge, income greater than 5 crore + 4% cess).

Capital Gains for shares can be long term or short-term. Long term is for t > 1 year and short term is for t < 1 year.

Shares were exempt from long term capital gains tax till 31st March’2018. In the Union Budget of the year 2018, this was changed. Starting April 2018, long term capital gains became taxable at the rate of 10 percent. Relating to this, there are two important provisions:

1. Exemption up to Rs. 1 lakh: In case of long-term capital gains arising out of equity shares and equity-oriented mutual funds, the tax is applicable only on the capital gains above Rs. 1 lakh. The first Rs. 1 lakh worth of long-term capital gain from this category is tax-exempt.

2. Grandfathering of capital gains: Since the capital gains from equity assets were non-taxable till the announcement of the budget in 2018, a reintroduction of the tax would have meant that even the gains earned till then would also become taxable. This is equivalent to introducing tax with retrospective effect. In order to avoid such a situation, the Finance Minister introduced a clause, which came to be known as the “grandfathering of the capital gains”.

Unlisted Shares

A Share which is not listed on a recognized stock exchange is an unlisted share and tax treatment of unlisted shares is not the same as the listed shares. Gains realised on these unlisted shares, if held for more than 24 months, are taxed as long-term capital gains at tax rate of 20% post indexation benefit. If held of less than 24 months, short term capital gains, added to the income of the investor and taxed at slab rate.

Mutual Funds

We must consider the income at two levels– income earned by the mutual fund scheme and income earned by the investor / unitholder.

As income earned within the wrapper i.e. mutual fund schemes is not taxed, we call it a pass-through vehicle. That is only reason you will never find a tax-free bond in a mutual fund portfolio.

Taxation is passed through to the unitholder and is based on holding period and type of mutual fund scheme (equity oriented and non-equity oriented)

Before understanding the taxation of mutual funds, let us first understand the criteria for equity oriented and non-equity oriented mutual funds.

Taxation is different for equity oriented mutual funds and non-equity oriented mutual funds.

Capital gains are classified into two categories: short term capital gains and long-term capital gains.
Long-term is defined as holding period of more than 3 years in case of non-equity-oriented funds, whereas the same is more than 1 year in case of equity-oriented funds. Capital gains booked before completion of this period would be treated as short term capital gains.

Key things to note:

1. All Funds of Funds will be taxed like non-equity-oriented funds. Only exceptions is for those FOF which are holding 95% of the exposure in those ETFs which in turn are holding 95% of the exposure in domestic listed equity.

2. ETFs, although, traded like stocks, will be taxed as per the portfolio allocation, for example, Nifty 50 ETF, which holds at least 95% in Indian listed stocks, will be taxed like equity oriented mutual funds whereas debt ETF will be taxed as non-equity-oriented funds as the underlying is 100% fixed income.

3. International Funds are taxed as non-equity-oriented funds

4. Gold Funds or Gold ETFs are taxed as non-equity-oriented funds

Portfolio Management Services

The structure of PMS is such that investor owns the securities in his/her own capacity. Minimum investment is 50 lakhs. As the investor holds the security directly in his own name, taxation is similar to that of equity shares. For every transaction there is tax implication. For example, if the PMS manager bought a share at 100 and sold it at 200 within a year, this transaction will result in short term capital gain. The PMS manager will reinvest the proceeds in some other opportunity so the cash out flow of tax is managed by investor himself. Dividend income from underlying securities is also taxable in the hands of investor. 

One important point to be noted here is that the onus of compliances and regulatory risks are on investor. So, the investor needs to clearly disclose any restriction to PMS manager at the time of opening of account. For example, if a promoter of a listed company invests in PMS, he clearly needs to instruct the PMS manager not to buy the shares of the company in which the investor is a promoter.

I am not a tax expert on tax matters, but with limited knowledge, management fees paid by the investor can be set off with the capital gains in the PMS.

Alternate Investment Funds

Alternate Investment Funds is a pooled investment vehicle (either structured as LLP or Company or Trust) which collects funds from sophisticated investors, whether Indian or foreign. (Minimum Investment is 1 Crore). 

To understand the taxation, we first have to understand the three categories of AIFs:

Category I: CAT I AIFs invest in start-up, early stage ventures, SMEs, social ventures, infrastructure or other sectors designated as economically and socially desirable by the government or regulators. They are closed-ended funds with a minimum tenure of three years. 

Category II: CAT II AIFs are those that do not fall under CAT I or CAT III and do not take borrowings for other than operational requirements. Category II funds will be closed-ended funds with a minimum tenure of three years. For example, Real Estate Funds, Private Equity Funds, funds for distressed assets comes under this category.

Category III: Category III funds are those that undertake complex trading strategies including investment in derivatives. Category III funds may be open or closed-ended. Long-Short Funds, PIPE Funds.

CAT I or CAT II AIFs have pass-through status for the purpose of taxation. Any income (or loss as well) except for business income generated from the investments is taxed (allowed as set off) in the hands of investor in the same manner and under the same head as it would have been if the income had been earned by the investor directly and not through AIF.

Business income is not permitted to be passed through to the investor and the fund pays tax on such income as applicable to the structure (Company pays 25%, LLP pays 30% and Trust at Maximum marginal Rate of 42.74%). 

CAT III funds do not have the pass-through status and all income is taxed at fund level. Taxation is very complex and unfavorable. I am leaving this to keep the article simple and easy to understand.

Market Linked Debentures (Listed)

As the name suggests, the returns of these products are linked to “variable X” in the market. This variable can be performance of Nifty. This contingent condition is put to make the product tax efficient. In a normal bond, coupon payments are taxed at marginal rate of taxation, which is high for HNIs. But when the issuer puts a contingent condition, the coupon can not be accrued as nobody knows, what will happen with the contingent condition. For example, a particular MLD may offer 7.5% annualized return to investor, tenure of MLD 24 months, if Nifty doesn’t close more than 75% down from the investment value. As chances of 75% drawdown is very negligible, it is almost certain that the issuer will pay 7.5% interest. Below is the taxation for three different conditions:

1. Investor sold the product before 1 year, in this case, all the gains will be treated as Short Term Capital Gains and will be taxed at marginal rate of the investor.

2. Investor sold the product after 1 year, in this case, gains are treated as long term capital gains and are taxed at 10%.

3. In case the investor holds the instrument till maturity, differential between buying price and maturity proceeds will be treated as interest income and taxed at marginal rate of taxation.

So, scenario 1 and 3 will lead to tax inefficiency and the whole idea of creating this product will be defeated. The wealth manager, who has sold the product, will arrange the buy-back of bond just before the maturity to make the returns tax efficient. For example, IIFL Wealth get this product buy backed in their fund IIFL Cash Opportunities Fund to give exit to their HNI Clients.

Gold

Taxation of gold depends on the form of investment.

For Physical Gold, Digital Gold, Gold Fund and Gold ETF, taxation is similar to that of non-equity oriented mutual funds. That is, for t > 3 years, indexation and 20% and for t < 3 years at slab rate of the investor.

But if you have invested through Sovereign Gold Bond, the interest income (2.75% or 2.5%) will be taxable at slab rate. For capital gains, if you have sold the units on exchange, in secondary market, taxation is similar to that of other forms of gold. T>3 years, indexation and 20%. For t < 3 years, at marginal rate of taxation.

Capital Gains are exempted if you have redeemed your SGB units to RBI.

When can you redeem (or early/premature redeem) your units to RBI? After 5 years from the respective date of issue on coupon payment dates OR compulsorily after 8 years from the date of issue.

Please note, digital gold is unregulated and hence should be avoided.