InvestorQ : How are the Fund of Fund (FOFs) taxed in India and is it the same as taxation of mutual funds?
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How are the Fund of Fund (FOFs) taxed in India and is it the same as taxation of mutual funds?

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Rutuja Nigam answered.
12 months ago

Fund of funds (FOFs) are very popular instruments abroad but in India they are yet to pick up in a significant manner. In the US, Europe and South East Asia, FOFs are quite popular as a tool of financial planning. Financial advisors and planners use FOFs to customise solutions to investors and FOFs offer the safest option. Here is what you need to know about the taxation of FOFs in India.

Currently, there is an anomaly in the treatment of FOFs in India. All FOFs are treated as non-equity funds for the purpose of taxation; even if the FOF is purely consisting of equity funds. According to the Income Tax Act, an equity mutual fund is one that invests more than 65% of the corpus in equity shares. Consequently, even arbitrage funds and equity oriented balanced funds are classified as equity funds due to the exposure to equities. However, FOFs were treated as non-equity funds even if the predominant investment was in equity funds. That restricted the popularity of FOFs in India. Treating all FOFs as non-equity funds has following implications.

1. The benefit of Section 80C cannot be extended to ELSS schemes since it is only available for equity schemes and even equity oriented FOFs are classified as non-equity schemes.

2. The period for long term classification is a holding period of 3 years and not 1 year. This worked against FOFs.

3. Short term capital gains would be taxed at the peak tax rate of the individual rather than at the concessional rate of 15% in case of equity funds

4. Long term capital gains will be taxed at 20% of index gains rather than at 10% with benefit of Rs.1 lakh tax free gains.

5. Lastly, FOFs will have to pay DDT (dividend distribution tax) of 29.12% on dividends declared inclusive of surcharge and cess.

It was actually the tax factor that made these FOFs relatively unattractive in the Indian context taking away a very powerful product from Indian investors.