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Taxation on Index funds and ETFs

  • Akshatha Sajumon
  • Jan 16 2022
  • 6 minutes
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ETFs and Index Funds have gained huge popularity in recent years. These are unique investment products that allow the investors to get the benefit of stock markets along with reduced risks. One of the crucial points of considerations while making an investment is the tax liability associated with each such product. It is often a deciding factor while making the investment decision.

Given below are the details of the tax structure of the tax incidence on the investments made in ETFs and Index Funds.

What are ETFs?

ETF is the abbreviation used for Exchange Traded Funds. This is a unique investment product that is relatively new to the Indian stock markets. These are funds that are formed out of a basket or a pool of stocks or securities. These funds track the underlying index for their performance. Such tracking may be subject to some errors or deviations that are known as tracking errors. The funds having lower tracking error and expense ratio are preferred by the investors for making investments in ETFs

What are Index Funds?

Index funds are also a basket of individual securities. These funds are similar to mutual funds in their nature of formation but their performance or returns are dependent on the underlying index that they track. Like ETFs, these returns are also prone to tracking errors and are also passively managed funds. Investment in index funds is also considered to be safer as well as cost-effective as compared to mutual funds.

Taxation of ETFs

Taxation is one of the crucial factors on the income earned from ETFs. Investors can earn income in two forms from ETFs namely, dividend income and capital gains. The tax liability for the income earned from ETFs is mentioned below.

  • Tax on dividends

The dividends earned from ETFs were earlier taxed in the hands of the company issuing such dividends. Such dividends were subject to DDT (Dividend Distribution Tax) at the rate of 15% excluding the applicable cess. However, from the financial year 20-21, the dividend earned from ETFs is taxed at the hands of the investors. This income is subject to tax at the applicable income tax slab rates for the investors. 

  • Tax on capital gains

Capital gains are levied at the time of sale or redemption of units of the ETFs. The profit earned through such transactions is subject to the levy of capital gains. Such capital gains are dependent on the type of ETF as well as the period of holding. The tax structure for capital gains is tabled below.

Types of ETFs Time frame for Short term capital gains Tax rate Time frame for Long term capital gains Tax rate
Equity ETFs Maximum 12 months 15% (plus Cess) under section 111A 12 months and more 10% (plus cess) on gains exceeding Rs. 1,00,000
Other ETFs (Debt ETFs, Gold ETFs, International ETFs)  Maximum 36 months Slab rates 36 months and more 20% with the benefit of indexation

 

Taxation of Index funds

Index funds are also subject to taxation on account of capital gains as well dividends earned. The dividend earned on the index funds is included in the taxable income of the investor. Such income is then taxed at the applicable slab rates.

The rate of taxation for capital gains, on the other hand, is dependent on the period of holding of the fund. This makes it an effective tax tool as capital gains come into the picture only when the units of the fund are redeemed. The details of the taxes levied on the investors of index funds are mentioned below.

Particulars Time frame for Short term capital gains Tax rate Time frame for long term capital gains Tax rate
Index Funds Maximum 12 months 15% (plus Cess) under section 111A 12 months and more 10% (pluss cess) on gains exceeding Rs. 1,00,000 (This is including all your direct equity and equity mutual funds)

Conclusion

ETFs and Index funds are relatively new as investment instruments in the Indian market. These products have gradually made their place in the investor’s portfolio over the years due to increased investor awareness and their multiple benefits over other investment products like mutual funds. Both these products have tax advantages and can be used as an effective investment instrument for gaining good returns at lesser tax liability. 


Frequently Asked Questions

Can equity index funds get the benefit of indexation in case of long-term capital gains?
No. Equity Index funds do not have the benefit of indexation in case of long-term capital gains.

Is dividend taxable for index funds and ETFs both?
Yes. Dividends earned through both funds are taxable at the hands of the investors. Such income is included in the taxable income of the investor and taxed at the slab rates that are applicable for each financial year.

What is a better investment product among ETFs and Index funds in relation to expense ratio?
The expense ratio of ETFs is relatively lower as compared to the expense ratio of index funds. This gives it an edge over the index funds.

What is the basic advantage of ETFs over index funds?
One of the fundamental differences between ETFs and index funds is the former’s ability to be traded in the open market like any other stocks. This is also considered to be the basic advantage of ETFs over index funds.

 

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