The concept and Tax effect of Switching in Mutual Funds

Hi, almost all of us are aware of investing in Mutual Funds and their respective Tax effects. However, some areas still remain Grey for some and one such area is Switching in Mutual Funds.

What is Switching?

It is withdrawal of money from one scheme of Mutual Fund and investing in the other scheme of Mutual Fund without actually bringing withdrawal money to the Bank. Switching can ONLY be done among various schemes of a Mutual Fund Company, thus, only intra-Switching can be done in Mutual Funds. Example: If one has invested in some scheme of Reliance Mutual Fund then Switching of that amount can only be done among other schemes of Reliance Mutual Fund and NOT from one scheme of Reliance Mutual Fund to a Scheme of HDFC Mutual Fund.

As Switch Out is treated as redemption of Mutual fund and a switch in is treated as fresh investment in the Mutual Fund scheme.

Benefits of Switching:

You just need to submit a duly filled and signed Transaction form for the same.
No need to wait for Money to get credited to your Bank account because, in Switching, money is transferred directly from one scheme to another.
No need to fill-in a separate application form for the same.
A strategy that can capitalise the opportunity in Mutual Funds whenever the same arrives etc.
Tax effect of Switching: Tax effects of switching are mainly same as in the case of withdrawal/redemption because almost everything that happens in case of withdrawal and reinvestment happens in case of Switching except that Money does not pass through the bank account. Capital Gains/(Losses) are Taxed in the similar way as in the case of withdrawal from Mutual Fund scheme. Same method is to be followed for computation of duration of investment.

The taxability of the income on sale/redemption of units and the rates at which such income is taxed is discussed below:

If the units are held as stock-in-trade:

If the units are held by an investor as stock-in-trade of a business, the said income will be taxed at the rates at which the normal income of that investor is taxed. The rates applicable to different investors are discussed at length in Note 1.

On sale of the units of an equity oriented mutual fund (as defined below) on a recognised stock exchange or to the Mutual Fund, the investor will also be charged with securities transaction tax (‘STT’), provided the transaction is also considered as a taxable securities transaction. In other cases, STT is not levied.

Any amount of STT paid in respect of taxable securities transactions entered into the course of business shall be allowed as deduction in computing “business income” in respect of such Taxable securities transactions.

If the units are held as investments:

If the units are held as investments, the tax rates applicable to the unit holder will depend on whether the gain on sale of units is classified as a short term capital gain or a long term capital gain. As per section 2(42A) of the Act, units of the scheme held as a capital asset, for a period of more than 12 months immediately preceding the date of transfer, will be treated as long-term capital assets for the computation of capital gains; in all other cases, they would be treated as short-term capital assets.

The tax rates applicable on short term or long term capital gains arising on transfer of units of a scheme, being an equity oriented mutual fund are stated in the following table

Nature of income Tax rate$
Short-term capital gains on sale either to the Mutual Fund or on a recognised stock exchange Capital gains tax to be payable at 15 percent* [applicable to all investors including Foreign Portfolio Investors (FPI)]
Long- term capital gains on sale either to the Mutual Fund or on a recognised stock exchange No capital gains tax payable by any investor.
* plus surcharge, if applicable and education cess (refer Note 2). In case of non-resident investors, the above rates would be subject to applicable treaty relief.

$ Additionally, STT would be payable at the rates specified in Para on STT.

Thus, while finalising the client’s Statement of Affairs and ITR, one must not only rely on Bank record, one must refer prior years Statement of Affairs and check if any Switching has been done among Mutual Fund schemes, take Tax effect of the same, affect the same in Statement of Affairs and proceed….