Should I pay tax if my “equity” mutual fund holds less than 65% of equity?

“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.

Now over to the screenshots of the SBI fund presentation.


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! 🙂

8 thoughts on “Should I pay tax if my “equity” mutual fund holds less than 65% of equity?

  1. Dear Pattu,

    Thanks. I hadn’t paid attention to income tax rules surrounding dynamic equity funds in particular.
    B/w, there is a copy / paste error in the following section.
    Non-equity funds: The gain associated with any unit which is less than 3Y old for an equity fund will be taxed as per slab.

    It should actually read as ; The gain associated with any unit which is less than 3Y old for a non-equity fund will be taxed as per slab.

  2. Thank you for taking the effort to actually help everyone clearly understand the taxation position.
    So the key take-away is (from a taxation perspective) – look out for the equity allocation in the month you are investing. Maybe the prior 60 days or so… to get a feel if you are likely to shoot below the 65% mark. Similarly, do so at the time you are planning to exit.
    Of course other factors have a bigger role to play when you are looking to enter/ exit.

    1. That is true , but very few funds are problematic like the one mentioned here. So as long as we are sure about the strategy of the fund, it should not be a problem.

  3. Equity asset allocation going below 65% is indeed resulting in complicated scenarios. It is going to be a very challenging task (if not impossible) for a lay investor to know that his Fund had gone below 65% in equity allocation (annual average of monthly averages, fine!).

    Can such investors take it this way: in case a dynamic equity fund deducts STT at the time of redemption, equity-like taxation applies; and in all other cases non-equity-like tax rules get invoked? STT deduction is seen on the account statement as on the date of redemption; but the equity allocation does not (of previous 12 months does not). Also, AMCs can charge STT only on equity-class funds, not on others, thus investors should be able to take their lead based on what the AMC did on the STT front – at least theoretically.

  4. Each AMC issues a “capital gains statement” for every client with break up of Scheme-wise. And that I suppose that this Capital gains Statement would have details of break up based upon your withdrawal / redemption date as to which transactions fall under “equity oriented” or “other than equity oriented” and its tax treatment.

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