NFO Distribution & Valuation - Chapter 3

NFO Distribution & Valuation - Chapter 3

The mutual fund offer document is the soul of the mutual fund offer, either to the NFO investors or even to the ongoing investors who buy from the scheme. Let us look at 3 types of offer documents of a mutual fund viz. NFOs, SIDs and SAIs.


New Fund Offerings (NFO)

An NFO is to a mutual fund what an IPO is to stocks. It represents the new issue of units to prospective clients with a view to raising AUM for a new fund or for an existing fund to fill up gaps in offerings as per SEBI classification. The offer is made through a legal document called the Offer Document. Here are the steps to an NFO.

  • AMC decides on a scheme to be taken to market based on the inputs from the Chief Investment Officer (CIO) on investment objectives that would benefit investors, and inputs from the Chief Marketing Officer (CMO) on what would be a marketable theme for mutual fund investors.
  • AMC then prepares the draft Offer Document for the NFO which has to be approved by the Trustees and the Board of Directors of the AMC. As per the existing mutual fund regulations, the trustees have to give an undertaking that the scheme is a new product and not a modification of an existing scheme.
  • The documents are then filed with SEBI and the comments on the draft Offer Document are incorporated. In case SEBI does not suggest any modifications, then within 21 working days of filing the same, AMC can issue the offer document in the market.
  • AMC decides on a roll out plan for the issue keeping in mind the market situation, the current appetite and simultaneously launches a PR campaign to make investors aware of the NFO. This has to be in line with the SEBI advertising code
  • AMC holds events, road shows and broker meets for intermediaries to make them familiar with the scheme and its unique features. Subsequently, the Offer Documents and Application Forms are distributed to intermediaries to enable application to the NFO.
  • With respect to an NFO, 3 dates are important viz. NFO Open Date, NFO Close Date and the Scheme Re-Opening Date. The AMC announces Sale and Re-purchase prices from the Scheme Re-Opening Date. This is only applicable for open ended funds since reopening date is not relevant to closed-ended funds.

Importance of Offer Documents To Investors

Investors get the details of the scheme through the Offer Document. This could either be the NFO of the scheme or an ongoing open-ended scheme in the continuous offer period. All the information required by the investor must be made available in the Offer Document. Here are some of the key contents of the offer document.

  • Basic information like nature of the scheme, investment objectives and strategy, terms of the offer, services available to investor etc.
  • The fundamental attributes of the scheme includes the type of scheme, portfolio theme, Investment objective, investment pattern, terms of the issue, special provisions like safety net, fees and expenses etc.
  • Offer Document can also be referred to understand the investment objectives, the various commitments made by the AMC etc. even after the NFO.
  • An investor is presumed to have read and understood the Offer Document before investing in it since the mutual fund investment is based on the principle of Caveat Emptor (let the buyer beware).
  • Mutual Fund Offer Documents have two parts viz. (a) Scheme Information Document (SID), which has details of the particular scheme and (b) Statement of Additional Information (SAI), which has statutory information about the fund.
  • In practice, SID and SAI are two separate documents although legally the SAI is part of the SID. Both documents are prepared in the format prescribed by SEBI
  • It needs to be noted that SEBI does not approve or disapprove Offer Documents but only gives its observations. Offer Documents are only vetted by SEBI and not formally approved by the regulator.

SEBI Scheme For Labeling Mutual Fund Products

SEBI has instituted a system of labelling mutual fund products to enable investors to easily assess its suitability to their investment objective and includes:

  • Nature of scheme such as to create wealth or provide regular income in an indicative time horizon.
  • A brief about the investment objective (in a single line sentence) followed by kind of product in which investor is investing (Equity/Debt).
  • A pictorial representation of the risk to the investor in a mutual fund product depicted using a Riskometer. This Riskometer will categorize the risk in the scheme intone of the five brackets.


Contents Of The SAI

The Statement of additional information (SAI) inter alia contains the following:

  • Information about Sponsors, AMC and Trustee Company (includes contact information, shareholding pattern, responsibilities, names of directors and their contact information, profiles of key personnel)
  • Information of service providers {Custodian, Registrar & Transfer Agent, Statutory Auditor, Fund Accountant (if outsourced) and Collecting Bankers}
  • Condensed financial information (for schemes launched in last 3 financial years)
  • Application process, rights of unit-holders and investment valuation norms
  • Tax, Legal & General Information (including investor grievance redressal mechanism, and data on number of complaints received and cleared, and opening and closing number of complaints for previous 3 financial years and for the current year to-date).
  • Every mutual fund must provide for download of its SAI on their official website. Investors can access the SAI of all mutual funds from AMFI website.
  • Material changes to the SAI have to be updated on an ongoing basis and uploaded on the websites of the fund and of AMFI.


How Mf Investors Can Take Decisions Based On Offer Document


The most important thing to look for in any scheme is the suitability to your specific needs. There is nothing like a one-size-fits-all approach in mutual funds. The offer document permits the investor to find answers to some or all of the following questions.

  • Is the investor eligible to invest in the scheme - The SID of the Offer Document provides a list of investor categories eligible to invest in the scheme. For example, this list could include Resident adult individuals, Karta of HUF, minors, partnership firms, LLPs, private and public limited companies, PSU, AOPs, cooperative societies etc. this segment also outlines the persons not eligible to invest in the scheme like residents of US / Canada, NRIs living in non-FATF nations etc.
  • Is the scheme suitable for the investor - The suitability of the scheme will depend upon multiple factors such as the financial need of the investor, the risk and return preferences, the investment horizon, liquidity needs, tax status etc. To facilitate this decision, the SID provides the Riskometer, outlines scheme risks, nature of the schemes, investment objectives of the scheme, asset allocation strategy, micro investment strategy of the fund, performance of existing schemes on a pure return basis and risk-adjusted return basis etc.
  • Whether the fund is open ended or close ended and how can the investor participate in the scheme. In case of closed ended scheme, units of the scheme can only be purchased in the secondary market or through interval offering. Open ended schemes are available for subscription round the year from the fund itself.
  • How does an investor apply for Units of a mutual fund scheme - While the previous point is more informative, this section is more practical and actionable. It provides information on who can invest, information to be provided in the application form, points at which the application can be submitted, the modes of payments for purchases made and the details to be provided for each option available for payments, and restricted modes such as third party payments etc. It also covers mandatory information to be provided such as PAN, bank account details and KYC details.
  • What is the price at which an investor can buy and redeem units of the scheme - This information set includes price at which investors can purchase and redeem units. This price depends on the Applicable NAV for the transaction based on the cut-off time prescribed for the particular type of scheme.
  • What is the maximum and minimum investment an investor can make - It provides the minimum amount of purchase that has to be made and the minimum balance that has to be maintained in the folio. The minimum amount for which redemption requests have to be made is also mentioned. This information is also available in the KIM (Key Information Memorandum).
  • What are the plans and options available to the investor and this includes the dividend option, growth plan, dividend reinvestment plan and options like the Regular Option and Direct Option. For ongoing scheme, this section also provides the NAV applicable to each of these sub-plans and sub-options.
  • What are the modes of investing available to the investor - This includes transacting directly with the mutual fund either physically or via Internet, through channel distributors, electronic mode, stock exchanges and others.
  • When and how to redeem their investment in the fund - The segment provides a summary of the Liquidity in the investment in the scheme. It also gives details of price for redemption, the cut-off times and the modes by which the payments will be made for different categories of investors. It also covers the right of the mutual fund to restrict or suspend redemptions.
  • What are the fees and expenses that an investor has to bear for investing in the mutual fund scheme - As per the current practice, fees are charged to the scheme and the NAV reflects the adjustment. The loads are paid by each investor out of their investment value at the time of exit.
  • What are the various sources of information available to the investor in mutual funds and this includes the KIM, the SAI, the SID, the AMFI website, the mutual fund website, SEBI website etc. It also covers where an investor can find information of the constituents of the mutual fund like financial information, performance, key personnel,
  • How are the Net Asset Value (NAV) of units of a mutual fund scheme calculated and what are the tax implications of the investment in mutual funds - This covers the tax implications of dividends and capital gains, if any.


What are the rights of the unit holders of the scheme? 

  1. Unit holders of the Scheme have a proportionate right in the beneficial ownership of the assets of the Scheme.
  2. When the Mutual Fund declares a dividend under the Scheme, the dividend warrants shall be despatched within 30 days of the declaration of the dividend.
  3. The Account Statement reflecting the new or additional subscription as well as Redemption / Switch of Units must be despatched within 10 business days
  4. The Trustee is bound to make such disclosures as are essential in order to keep the unit holders informed about any information which may have a material adverse bearing on their investments.
  5. The appointment of the AMC for the Mutual Fund can be terminated by majority of the Directors of the Trustee Board or by 75% of the Unit holders of the Scheme. In fact, 75% of the Unit holders can also pass a resolution to wind-up a Scheme.
  6. Trustee shall obtain the consent of the Unit holders when required by SEBI, when any decision is of material interest to the unit holder and when the trustee decides to wind-up the scheme.
  7. Trustee shall also ensure that no change in the fundamental attributes of any Scheme shall be carried out unless written communication about the proposed change is sent to each Unit holder and Unit holders are given an option to exit at the prevailing NAV without any Exit Load
  8. In specific circumstances, where the approval of unit holders is sought on any matter, the same shall be obtained by way of a postal ballot or such other means as may be approved by SEBI.


Traditional Distribution Channels - Individuals

Individuals as agents were common in the case of UTI and LIC. In fact, LIC relied largely on their network of individual opinion builders to sell their products. These individuals also facilitated the investments in Government’s Small Savings Schemes and also sold Fixed Deposits and Public Issues of shares of companies, either directly, or as a sub-broker of some large broker. For the mutual fund industry, these individuals (due to their existing contacts and networks) continue to be a veritable source of new business.

However the proliferation of products, the complexity of new products, the technology driven methods of selling and greater compliance and other statutory requirements have forced MFs to go beyond the individual agent model. While individual distributors could bring in familiarity they have a shortcoming in that they cannot handle scale. That is where the need for institutional distribution comes in handy.


Distribution Channels - Institutional

The changing competitive context led to the emergence of institutional channels of distribution for a wide spectrum of financial products. These broadly comprised of –

  • Brokerage firms and other securities distribution companies, who widened their offering beyond company Fixed Deposits and public issue of shares
  • Banks, who started viewing distribution of financial products as a key avenue to earn fee-based income, while addressing the investment needs of their customer
  • Non-banking finance companies (NBFC) with multiple branches.

As a result, the distribution setup got re-aligned towards 3 broad categories

  • Individuals as Independent Financial Advisors (IFAs). The bigger IFAs operate with back-office support while they focus on sales and client relationships. Many of these IFAs have gradually transformed into full-fledged financial planners and mutual fund selling has become a means toward an end.
  • Non-bank distributors, such as brokerages, securities distribution companies and non-banking finance companies. They are basically into cross selling where the existing relationships are leveraged to sell mutual funds in a systematic manner. They are a key component in the entire distribution chain.
  • Bank distributors or Bancassurance partners have the advantage of all-India or regional network of locations meant that the institutional channels and they, can deal with product originators as equals, and negotiate better terms than what the agents could manage. They are also able to use distribution to absorb their fixed costs better.


Futuristic Channels of Distributing Mutual Funds

While there have been other channels like SHOs and post offices, the big thrust to distribution has come from the internet penetration. It has helped even small distributors to handle scale without too much of an investment. Here are some of the big trends.

  • Internet gave an opportunity to mutual funds to establish direct contact with investors. Investors can now access the website of the mutual fund and deal directly with the fund. Direct transactions afford scope to optimize on the commission costs involved in distribution.
  • Other electronic/internet based modes of conducting financial and non-financial transactions include those offered by banks, financial institutions, distributors, registrar and transfer agent, electronic platforms provided by stock exchanges such as NSE’s MFSS and BSE’s STAR platform.
  • Apps downloaded on the mobile phone and used in smart phones for transactions are the new development in distribution. Smart apps allow potential customers to not only read the research but also to directly move to a call-to-action such that the transaction can be executed seamlessly.
  • The latest trend is the use of BOTs and other means of artificial intelligence and machine learning to customize products to the needs of the customers. This is catching on as a new channel of distribution for mutual funds.

Apart from these, the stock exchange is becoming an important institutional channel for distribution of mutual funds. Stock exchanges have managed to ride on the equity cult in the country and the power of communication networks to establish a cost-effective all-India network of brokers and trading terminals. In short, this is a network that can be adequately leveraged for selling mutual funds effectively to customers.

Now, SEBI has facilitated the buying and selling of mutual fund units through the stock exchanges route. Both NSE and BSE have developed mutual fund transaction engines for the purpose. The premise is that the low cost and deeper reach of the stock exchange network can increase the participation of retail investors in mutual funds and make mutual funds a truly retail product.


Qualifications To Become A Mutual Fund Distributor

SEBI has prescribed a Certifying Examination; passing which is compulsory for anyone selling mutual funds, whether as IFA, or as employee of a distributor or AMC. Here are the pre-requisites.

  • The individual needs to pass the Certifying Examination prescribed by SEBI. Experienced persons can attend a prescribed refresher course
  • AMFI has introduced the Know Your Distributor (KYD) process to verify the correctness of the information provided in the registration documents and to have verification of the ARN holders and includes a bio-metric process
  • Self-attested copy of the PAN card and specific documents as proof of address to be submitted along with application form with original for verification
  • Bio-metric process mandatory for individual distributors. For non-individual distributors, bio-metric process will be conducted on specified authorized persons
  • An acknowledgement confirming the completion of KYD process is received from the POS and copy is sent to the empanelled AMC
  • Under new regulations, after passing the examination and completing KYD, the next stage is to register with AMFI. On registration, AMFI allots an AMFI Registration Number (ARN). With the ARN No., the IFA / distributor / stock exchange broker can get empanelled with any number of AMCs


Channel management practices in mutual fund distribution

The channel management practices essentially pertain to commission structures, treatment of direct plans & regular plans and SEBI stipulations related to commission disclosure. Let us look at the highlights of these 3 sub-heads.

Commission Structures

There are no SEBI regulations regarding the minimum or maximum commission that distributors can earn. However, SEBI has laid down limits on what the total expense ratio or TER (including commission) for a scheme category. Any excess will have to be borne by the AMC and cannot be charged to the scheme. Broadly, commissions are classified into upfront commissions and trail commissions.

Initial or upfront commissions were quite simple when entry loads were charged. However, after entry loads were banned in 2009, upfront commission to distributors will be paid by the investor, based on his assessment of service rendered and value-added.

Trail commission is paid for loyalty i.e. how long the money stays in the fund or the scheme. The commission payable is calculated on the daily balances and paid out periodically to the distributor as per the agreement entered into with AMC. Trail commission is normally paid by the AMC on a quarterly basis or monthly basis. Since it is calculated on net assets, distributors also benefit from increase in net assets arising out of valuation gains.

Direct and Regular Plans

The direct plan is for investors who wish to invest directly in the mutual fund without routing the investment through a distributor. The Plan will have a lower expense ratio since there are no distribution expenses or commissions involved. The plan will have a separate NAV (effective Jan-13) that will reflect the lower expenses under this Plan. Under the Regular plan the investor indicates a distributor through whose services the investment decision was made and executed. The AMFI Registration Number (ARN) is made available by the investor in the application form and the mutual fund pays the transaction charges and commissions to the distributor so identified. The expenses under the Regular plan are higher because of the distribution commissions involved.

Commission Disclosure

SEBI has mandated AMCs to disclose on their websites the total commission and expenses paid to distributors respect to non-institutional (retail and HNI) investors as under.

  1. Having multiple point of presence (More than 20 locations)
  2. AUM raised over Rs. 100 crore across industry in the non-institutional category
  3. Commission received of over Rs. 1 crore annually across industry
  4. Commission received of over Rs. 50 lakhs from a single AMC

AMCs must also submit the above data to AMFI, which will disclose consolidated data in this regard on its website. In addition to the total commission and expenses paid to distributors, mutual funds / AMCs need to make additional disclosures regarding distributor-wise gross inflows, net inflows, average assets under management and ratio of AUM to gross inflows.


SEBI Regulations Related To Sales Practices

Distributors can claim commission on investments made through them by their clients but no commission is payable on their own investments. The distributors have to disclose all the commissions (in the form of trail commission or any other mode) payable to them for the different competing schemes of various mutual funds from amongst which the scheme is being recommended to the investor. Rebating (cash back) is banned as per AMFI code.

SEBI Advertising Code

The important provisions of the SEBI advertising code are as under:

  • Advertisements shall be accurate, true, fair, clear, unambiguous and concise
  • Advertisements shall not contain statements based on assumption/projections and shall not contain any testimonials
  • Advertisements shall not disguise the significance of any statement. Advertisements shall not contain statements which directly or indirectly mislead the investor.
  • No celebrities shall form part of the advertisement for a fund, although celebrities are allowed for industry level advertising subject to SEBI approval
  • Advertisements should not be designed to exploit the lack of experience or knowledge of the investors. Extensive use of technical or legal terminology or complex language and the inclusion of excessive details must be avoided
  • Advertisements shall contain information that is current and consistent with the disclosures made in the Scheme Information Document
  • No advertisement shall directly or indirectly discredit other advertisements or make unfair comparisons or show competing players in poor light deliberately
  • All advertisements must be accompanied by a standard warning in legible fonts which states ‘Mutual Fund investments are subject to market risks, read all scheme related documents carefully’
  • In audio-visual advertisements, standard warning shall be audible in a clear and understandable manner
  • The dividends declared / paid must be mentioned in Rupees per unit along with the face value of each unit of that scheme and the prevailing NAV at the time of declaration of the dividend
  • While advertising pay out of dividends, all advertisements must disclose that the NAV of the scheme would fall to the extent of dividend payout and statutory levy


Transparency of Return Information in advertisements

When the mutual fund scheme has been in existence for more than three years returns can be disclosed as under

  • Point-to-point returns on a standard investment of Rs. 10,000/- shall also be shown in addition to CAGR for a scheme
  • Performance advertisement shall be provided in terms of CAGR for the last 1 year, 3 years, 5 years and since inception. Performance advertisement of mutual fund schemes should provide the return information in comparison with the benchmark index and calculated based on TRI (Total Returns Index).
  • Where the scheme has been in existence for less than one year, past performance shall not be provided
  • For money market schemes or liquid schemes, the performance can be advertised by annualizing yields if a performance figure is available for at least 7, 15 and 30 days
  • For the sake of standardization, all funds shall be compared only to the comparable index like Nifty for large cap, Mid cap index for mid cap funds etc.
  • Performance of other schemes managed by the fund manager shall be disclosed in a summarized manner and in internet-enabled media with appropriate hyperlinks


Accounting And Expenses In Mutual Funds

Understanding Net Assets of Scheme

Unit-holder funds in the scheme are commonly referred to as “net assets”. The assets of the scheme are the investments held by it. This along with the accrued income which includes dividend or interest due on securities held in the portfolio but not yet received, and receivables, such as amount due on shares sold, constitute the total assets. The liabilities include short-term liabilities and accrued expenses, payables for securities bought and borrowings to meet liquidity needs. Here is what we can apprehend about net assets.

  • Net assets includes the amounts originally invested, the profits booked in the scheme, as well as appreciation in the investment portfolio
  • Net assets increase when the market prices of securities held in the portfolio increase, even if the investments have not been sold (profits booked and MTM)
  • A scheme cannot show better profits by delaying payments. While calculating profits, all the expenses that relate to a period need to be considered as long as it is accrued for that accounting period
  • Any income that relates to the period will also boost profits, irrespective of whether or not it has been actually received in the bank account as long as it is accrued.

Net Asset Value (NAV)

NAV refers to the value of each unit of the scheme. This is equivalent to:

Unit-holders’ Funds in the Scheme (Net Assets) / No. of Units outstanding

Illustration on NAV

Value of stocks: Rs. 150 cr

Value of bonds: Rs. 67 cr

Value of money market instruments: Rs. 2.36 cr

Dividend accrued but not received: Rs. 1.09 cr

Interest accrued but not received: Rs. 2.68 cr

Fees payable: Rs. 0.36 cr

No. of outstanding units: 1.90 cr

NAV = (Value of stocks + Value of bonds + Value of money market instruments + Dividend accrued but not received + Interest accrued but not received – Fees payable) / No. of outstanding units

NAV = (150 + 67 + 2.36 + 1.09 + 2.68 – 0.36) / 1.90 = 222.77 / 1.90 = Rs. 117.25

Understanding the concept of mark to market (MTM)

The process of valuing each security in the investment portfolio of the scheme at its current market value is called ‘mark to market’ i.e. marking the securities to their market value. This is done so that at any point of time, the NAV reflects the true worth of each unit of the scheme. For example, by valuing the NAV without MTM would mean that one of the parties is at an advantage over the other.

Issuing fresh units at a price lower than NAV will result in the post issue NAV coming down for all investors. Similarly, redeeming units at price lower than NAV will increase the NAV for the remaining investors. Both are unfair and that is why MTM is used.


Concept of Sale Price, Re-purchase Price and Loads

A unique feature of open-ended schemes is the ongoing facility to acquire new units from the scheme (“sale” transaction) or redeem units back to the scheme (“re-purchase transaction”). Prior to 2009, schemes were permitted to keep the Sale Price higher than the NAV by imposing an entry load. However, with the entry load being banned, the scheme has to sell funds at the NAV only.

Schemes are permitted to keep the Re-purchase Price lower than the NAV. The difference between the NAV and Re-purchase Price is called the “exit load”. The exit load is normally conditional and is subject to a shorter holding period. This is done to discourage investors to trade in and out of the fund like equity shares.

Expenses in a mutual fund

Broadly there are 2 types of expenses in a mutual fund:

Initial Issue expenses are incurred at the time of launching a scheme in an NFO. It is a one- time expense. Schemes launched prior to the passage of the SEBI (Mutual Fund) Amendment Regulations, 2008 bore the initial issue expenses up to 6%. Post 2008, these expenses are borne by the AMC.

Then there are recurring expenses for running the fund and to manage the money raised from the investors. These can be charged to the scheme. SEBI has defined the types of expenses that can be charged to the scheme.

  • Fees to service providers like Trustees, RTA, Custodians, Auditors etc
  • Marketing and selling expenses including commission to the distributors
  • Expenses on statutory investor communication, account statements
  • Listing fees and Depository fees
  • Insurance premium paid by the fund

Expenses that are not permitted to be charged to the scheme shall be borne by the AMC or sponsors. Brokerage and transaction cost incurred for the purpose of execution of trade may be capitalized to the extent of 0.12 percent for cash market transactions and 0.05 percent for derivatives transactions respectively. Any payment of brokerage and transaction costs above that can be charged to the scheme.

However, there are some expenses that cannot be charged. Some examples of costs that cannot be charged to the scheme include penalties for infraction of laws, interest on delayed payment to unit holders, fund accounting fees and other generic costs.


Key Accounting And Reporting Requirements

Here are some of the key requirements on the accounting and reporting front.

  • The accounting and audit of the schemes must be distinct from the accounts of the AMC
  • NAV is to be calculated up to 4 decimal places in the case of index funds, liquid funds and other debt funds. For equity and balanced funds NAV is to be calculated up to 2 decimal places
  • Investors can hold their units even in a fraction of 1 unit. However, such fractional units cannot be sold on the stock exchange.


Mutual Fund Valuation Norms

A mutual fund scheme invests in a portfolio of securities created and managed based on the investment objective and strategy of the scheme. Investments include stocks, money market instruments, privately placed debentures, securitized debt, gold, real estate assets etc. Here are the key valuation norms.

  • A traded security (that is traded on a recognized stock exchange) shall be valued at the last quoted closing price. Wherever a security is traded in the market on the date of valuation, its closing price on that date is taken as the value of the security in the portfolio. All money market and debt instruments with residual maturity up to 30 days shall be valued at the weighted average price on the valuation date
  • A non-traded security is one that has not been traded for thirty days prior to the valuation date. A non- traded or thinly traded equity instrument may be valued using the capitalization of earnings method, using the PE ratio of comparable traded securities for capitalization after discounting it for lower liquidity
  • A non-traded or thinly traded debt security is valued on the basis of the yield matrix prepared by an authorized valuation agency. The yield matrix estimates the yield for different debt securities based on the credit rating of the security and its maturity profile.
  • There are detailed norms on when a security is to be treated as a Non-Performing Asset (NPA), how much is to be written off (treated as a loss) at various points of time and when the amounts written off can be added back to the NAV.
  • Where no-traded or thinly traded securities represent more than 5% of the net assets of a scheme, an independent valuer must be appointed.
  • AMFI has appointed CRISIL and ICRA to provide security level pricing of fixed income securities with maturity greater than 60 days for uniform valuation


Taxability Of Mutual Funds

A mutual fund being a trust is exempt from tax on its income and earnings under section 10(23D) of the Income Tax Act. Since the returns of the mutual fund are passed through to its investors, the returns are taxed in the hands of the investors. A mutual fund distributes the returns to the investors in the form of periodic dividends and appreciation in the value of units. The tax liability will depend upon the type of mutual fund scheme, the type of investor and the period of holding. Here are some important definitions from tax point.

Equity-oriented scheme means “(i) the Unit scheme, 1964 made by the Unit Trust of India; and (ii) such fund where 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 such fund. All others that do not fit into the above definition will be classified as non-equity funds.

Securities Transaction Tax (STT)

STT is a tax on the value of transactions in equity shares, derivatives and equity mutual fund units. There is no STT on debt funds or money market funds (any fund classified as non-equity). STT is only applicable for Investors selling Equity oriented Mutual funds.

STT on Purchase of units of equity oriented mutual fund (NIL)

Sale of units of equity oriented mutual fund (delivery based) - 0.001%

How mutual fund investors are taxed?

The tax incidence in the hands of the investor in a mutual fund can be summarized as under:

In case of investor in an equity-oriented mutual fund scheme

  • Will pay STT on the value of the transactions of sale (0.001%) of units in the stock exchange; or on re-purchase (0.001%) of the value sold
  • Will be classified as long term capital gains tax (LTCG) if the units are held for more than a year. Effective April 2018, such gains will be taxed at a flat rate of 10% above annual LTCG off Rs.1 lakh.
  • Will be classified as short term capital gains if the units are held for less than 1 year and capital gains will be taxed at 15% plus surcharge and education cess
  • Dividends on equity fund will be tax free in the hands of the investor but equity funds will attract 10% DDT plus surcharge and cess.

In case of investor in a debt-oriented mutual fund scheme

  • Will not be subject to any STT charges
  • Will be classified as long term gains if held for more than 3 years and will bear a tax on long term capital gains at 20% with the benefit of indexation
  • Will be classified as short term capital gains if held for less than 3 years and will be taxed as per the investor’s applicable tax slab
  • Will receive any dividend free of tax; but the scheme would be subject to DDT of 25% plus cess and surcharge taking the total cost to 29.12%.

Setting off Gains and Losses under Income Tax Act

Here are a few key provisions pertaining to set-off you must be familiar with.

  • Capital loss, short term or long term, cannot be set off against any other head of income (like salaries or interest income)
  • Short term capital loss can be set off against short term capital gain or long term capital gain
  • Long term capital loss can only be set off against long term capital gain

However, there are also some limitations to such set-off benefits.


Limitations on Set-off in case of Mutual Fund Dividends

It is provided that:

  • If, an investor buys units within 3 months prior to the record date for a dividend and
  • Sells those units within 9 months after the record date, any capital loss from the transaction would not be allowed to be set off against other capital gains of the investor, up to the value of the dividend income exempted.


This is intended to avoid the arbitrage that this could offer. For example, if you know the quantum of dividends to be declared by the equity funds, you can take the dividend out tax free and then write off the resultant capital loss against your other capital gains. This is called dividend stripping and denies government tax revenues. This provision is basically intended to plug the loophole.


Limitations on Set-off in case of Bonus Units

Just as dividend stripping is possible to save taxes, bonus stripping is also possible. Here is how it works.


Suppose an investor buys units of a scheme at Rs30. Thereafter, the scheme declares a 1:1 bonus issue. I.e. the investor receives 1 new unit, for every unit that was bought earlier. Logically, the NAV of the scheme will halve, and it is likely that the units would now have a value of Rs15. At this stage, if the investor sells the original unit at Rs 15 and a notional loss of Rs 15 is incurred.

However, such capital loss is not available for setting off against capital gains, if the original units were bought within a period of 3 months prior to the record date of the bonus issue and sold off within a period of 9 months after the record date of the bonus issue. In such cases, the capital loss will be treated as the cost of acquisition of the bonus units.