“I checked the monthly fact sheet of my equity mutual fund and found that the equity allocation was less than 65% of domestic equity shares. Does this it will be classified as a debt mutual fund and I have to pay tax on it?”. “Can a mutual fund willfully reduce its equity holdings from the 65% limit stipulated by the taxman?”
Such questions are asked from time to time and the recent post on Dynamic Mutual Funds vs Balanced Mutual Funds also triggered a similar discussion (in which my response was not correct).
The exact definition of an open-ended equity oriented fund is the following:
As per the prevailing provisions of Section 115 R(2) of the Income-tax Act, 1961, the Scheme will be categorized as an “open ended equity oriented fund” if the investible funds are invested by way of equity shares in domestic companies to the extent of more than 65% of the total proceeds of the Scheme. Further, as per the provisions of the above Section, the percentage of equity shareholding of the Scheme shall be computed with reference to annual average of the monthly averages of the opening
and closing figures
Source: ICICI Dynamic Plan SID (page 49)Thanks to Dr. Ramesh Mangal for pointing me to the source and exact wording.
Here the “monthly averages of opening and closing figures” refers to the monthly average of the month in which units were purchased (opening figure) and the month in which units were redeemed.
So even if the equity allocation is less than 65% for one month, it is the average of the average monthly allocation that matters (see examples below).
The presentation document of SBI Dynamic asset allocation fund presents nice examples of this rule. The reason being the fund has an asset allocation policy in which the equity holding can swing from 0 to 100% and fixed income from 100% to 0%.
Therefore the answer to “Can a mutual fund willfully reduce its equity holdings from the 65% limit?” is Yes! If it says on in the scheme information document. Of course, many funds use arbitrage to avoid this messy situation. The point is, if a fund says that it can reduce equity holdings below 65%, then it can.
Key takeaways: If we invest in such a dynamic asset allocation fund and it says so in its investment strategy that equity allocation can reduce below 65%, then the onus is upon us to determine the monthly average asset allocation from the fact sheet for each month we invested in the fund, take the average of such averages and check if it is above 65% (equity fund) or not (non-equity fund).
Equity funds: The gain associated with any unit which is less than 1Y old for an equity fund will be taxed at 15% +cess. If above 1Y old, it is tax-free.
Dividends are tax-free.
Non-equity funds: The gain associated with any unit which is less than 3Y old for an non-equity fund will be taxed as per slab. If above 3Y old, at a flat rate of 20% + cess with cost inflation-indexed purchase price.
Dividends are taxed at source at the rate of 28.325%. See Budget 2015: Revised Dividend Distribution Tax.
And of course, avoid such funds! 🙂