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Innovative Tax Free MIP Mutual Funds

Mutual Fund MIP Schemes are a conservative fund. They invest a large part of the corpus (around 75-90%) in fixed income products for safety and stable income; and the balance (around 10-25%) in equities to boost the returns.

Recently, mutual fund companies have tweaked this portfolio distribution and introduced an innovative scheme... commonly known as an Equity Income Plan.

The idea behind this variation is to generate returns with "zero tax", without compromising on the risk at all.

So these funds to still cater to the conservative investors, but improve the returns by eliminating the tax burden.

Let's go step by step to understand the logic behind these Equity Income Mutual Fund Plans:

Earlier taxation on MIP schemes

For income tax purposes, MIP schemes are treated as debt-based funds.

Until last year,
a) Capital Gains for holding period less than one year were considered as Short Term Capital Gains. The investor had to add, such short-term gains, to his total taxable income and pay tax on it as per his/her income tax slab rate.

b) Capital Gains for holding period more than one year were considered as Long Term Capital Gains. The investor had to pay tax on such long-term gains either @10% without indexation benefit or @20% with indexation benefit, whichever was lower.

c) Dividend income from MIP schemes attracted Dividend Distribution Tax of 25% (plus surcharge and cess).

Mutual Funds innovate MIP Schemes into tax free Equity Income Plans 

Change in Income Tax Rules

Last year the taxation on MIP schemes (or rather for all non equity-oriented schemes) was changed. Now,

a) Till three years the gains are considered as Short Term Capital Gains. These will be added to your total income. Accordingly, tax payable would be as per your income tax slab rate.

b) Only when the holding period exceeds three years, the gains would be classified as Long Term Capital Gains. Also, the tax rate would be @20% with indexation benefit. (The option of 10% without indexation benefit has been removed.)

c) Dividend income from MIP schemes continues to attract Dividend Distribution Tax of 25% (plus surcharge and cess). 
[IMPORTANT: There is, however, a change in how this DDT is calculated; which results in higher tax outgo even though the rate is same - Read Now Pay More Tax On Your Dividend]

Beneficial tax treatment on equity-oriented funds

Funds that invest a minimum 65% of the their corpus in Indian Equity Markets are classified as equity oriented funds. They enjoy favourable tax treatment as under:

a) Capital Gains for holding period less than one year are considered as Short Term Capital Gains. These are taxed @15% (plus surcharge and cess).

b) Capital Gains for holding period more than one year are considered as Long Term Capital Gains. These are totally tax free.

c) Dividend income is also tax free.

How is Equity Income Fund structured to pay zero tax

To be classified as an equity-oriented fund and enjoy zero tax on returns, the Equity Income Fund has to have an equity exposure of more than 65%.

But that would increase the risk dramatically; and the whole purpose would be lost. (In fact, it would then be no different from the traditional Balanced Fund).

So, it does take 65%+ equity exposure... but with a twist. It fully hedges a part of the equity investment, by taking an equal but opposite exposure to the equity derivatives. In simple terms, this part equity exposure, that is hedged, works as an Arbitrage Fund.

As I had explained in my earlier blogs, even though Arbitrage Funds invest in equity and equity derivatives, they are structured to be as safe as a debt-based fund. Naturally, the returns too would be in line with debt-based funds i.e. 6-9%.

(Read : Baffled by Arbitrage Funds? Here's the simple explanation and Arbitrage funds : Excellent way to park short-term money)

Thus, a typical Equity Income Plan will invest in 
- Simple and Straightforward Equities (20-40%)
- Arbitrage Opportunities (20-40%) and
- Simple and Straightforward Debt (20-40%)

In other words, Equity Income Plan is a combination of an equity fund, an arbitrage fund and a debt fund.

- from safety perspective it is as good as a typical debt-based MIP Scheme
- from taxation perspective it is an equity-oriented fund, where returns are tax free (if held for more than a year).

Ideally, I prefer keeping each type of investment separate for higher flexibility and efficient portfolio management. Moreover, over a 3-5 year period even the MIPs could practically become tax free depending on the inflation.

However, for the conservative and short-term investors, Equity Income Plans are a nice innovation from the mutual fund companies.

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