Capital Gains on Mutual Funds

Capital gains rules and rates have changed frequently in recent years and can change again. This article is for general information and does not constitute tax advice.

Classification decides everything

A mutual fund’s tax treatment depends entirely on how it’s classified, not on what it’s called or marketed as. A fund is “equity-oriented” only if it invests at least 65% of its assets in the equity shares of domestic companies. Everything else, including debt funds, most hybrid funds, and notably funds that invest primarily in foreign or international equity, falls outside that definition and gets a different, generally less favourable, treatment.

Equity-oriented funds

Units held for more than 12 months qualify for long-term treatment. Short-term capital gains (12 months or less) are taxed at 20% flat under old Section 111A. Long-term capital gains (over 12 months) are taxed at 12.5% flat under old Section 112A, on gains exceeding ₹1,25,000 in a financial year; gains up to that threshold are exempt. Both figures were raised in July 2024, from 15% and 10% respectively, alongside the exemption limit moving up from ₹1 lakh. Gains accrued up to 31 January 2018 remain grandfathered and exempt for units acquired before that date, a much older provision that still occasionally matters for long-held investments.

The exception people don’t expect: arbitrage funds

Arbitrage funds market themselves on low volatility and behave, in practice, more like a cash-equivalent than an equity fund. But the classification test looks only at the balance sheet, not the strategy: an arbitrage fund typically holds most of its assets in equity shares, with the price risk hedged away through offsetting derivative positions, so it clears the 65% test and is taxed as an equity-oriented fund. Investors who assume arbitrage funds get debt-style treatment because of how they behave are working from the wrong test, and typically end up pleasantly surprised at the lower long-term rate rather than caught out by it, but it’s worth confirming a specific fund’s actual equity allocation rather than assuming from its risk profile.

Debt and other “specified” mutual funds

Since 1 April 2023, under old Section 50AA, mutual funds that don’t qualify as equity-oriented, including debt funds, most hybrid funds, gold-linked fund-of-funds, and international equity funds, are treated as giving rise to deemed short-term capital gains, taxed at slab rate, regardless of how long the units were actually held. There’s no long-term treatment and no indexation for these at all if acquired from that date onward.

Units of such funds acquired before 1 April 2023 retain the older treatment: long-term if held over 24 months, taxed at 12.5% without indexation, or short-term at slab rate if held less than that. International or foreign-equity funds catch a lot of investors by surprise here, since they hold equities, just not domestic ones, and end up taxed like a debt fund rather than like an equity fund.

Dividend stripping and bonus stripping: two anti-avoidance rules worth knowing

Buying units shortly before a dividend or bonus record date and selling shortly after, purely to book a paper loss while the underlying investment is barely held at all, is specifically targeted by anti-avoidance provisions. Where the pattern fits, the resulting loss is disallowed to the extent of the dividend or bonus benefit received, regardless of how the transaction is otherwise structured. This has been part of the law for a long time and continues to apply; it’s worth being aware the mechanism exists before treating a record-date trade as a straightforward tax-loss harvest, rather than relying on any specific holding-period figure without checking it against the current rules first.

Switches and set-off

Switching between schemes, including moving between growth and dividend options within the same fund, is treated as a redemption and a fresh purchase, triggering gains on the switch itself. On set-off, short-term loss can be used against both short-term and long-term gains, but long-term loss can only be set off against long-term gains, the ordinary rule that applies across capital assets generally.