Mutual funds and portfolio management service (PMS) are two popular vehicles by which people can invest in portfolios curated by experts. Both have their distinctive features in terms of ticket size, costs, transparency, taxation, etc. However, what matters most to investors is the money that they receive in hand, that is, their post-tax returns. Hence, it is critical to understand the taxation aspect of mutual funds and PMS in detail.
Let us understand this with an example. Suppose, in April 2021, Hiya invested ₹50 lakh in Mutual Fund A and was allotted 50,000 units at ₹100 per unit. The fund manager then invested in a diversified portfolio of 25 stocks. During the year 2021-22, the fund manager sold stock X and invested the amount in stock L. As on 31 March 2022, the net asset value (NAV) of the mutual fund units is ₹105 per unit. As mutual funds have a tax pass-through status, an investment in these funds is taxed only when the investor sells the units and not when any activity is undertaken by the fund manager or when the NAV changes. Since Hiya hasn’t sold her investment in Mutual Fund A, there will be no tax implication for her for FY2021-22.
Let’s assume that Hiya sold her investment in Mutual Fund A in May 2022 and received a redemption amount of ₹55 lakh. The difference between the sale value of ₹55 lakh and the cost of ₹50 lakh, that is, ₹5 lakh will be the Long Term Capital Gains (LTCG) as the mutual fund units were held for a period of more than one year. LTCG tax of ₹41,600 will be payable on the sale of Mutual Fund A by Hiya. It is also pertinent to note that due to the mutual fund pass-through status, there is tax deferment until the time the unit holder disposes of the units. If the investor holds the mutual fund units for the long term, this tax deferment can be a huge advantage considering the time value of money.
Let’s take another example. Let’s suppose that Khushi invested ₹50 lakh in PMS-B in April 2021, and then the PMS manager invested in a diversified portfolio of 25 stocks. During the year 2021-22, the PMS manager sold stock Y for ₹7.5 lakh which was purchased for ₹5 lakh. The fund manager invested the same amount of ₹7.5 lakh in stock M. Unlike in the case of mutual funds, in a PMS, the stocks are purchased and sold from the demat account of the investor. Hence, this will be taxed as capital gains for FY2021-22. Since the investment was held for less than 12 months, Khushi will pay tax of ₹39,000 on the short- term capital gain of ₹2.5 lakh (sale value of Y of ₹7.5 lakh minus its purchase cost of ₹5 lakh). Let’s assume that the PMS fund manager sold the investment in stock M for ₹10 lakh in May 2022 and invested the same amount in stock N. Again, in this case, Khushi will have to pay short-term capital gain tax of ₹39,000 on the capital gain of ₹2.5 lakh (sale value of M of ₹10 lakh minus its purchase cost of ₹7.5 lakh).
As seen in the above example, Hiya who invested in a mutual funds got post-tax returns of ₹4,58,400, whereas Khushi who invested in a PMS got post-tax returns of ₹4,22,000. Hiya got a higher post-tax return than Khushi just by choosing a more tax effective investment.
One also needs to take cognizance of the fact that if there are numerous or frequent transactions of stocks or future and options trading, then, instead of being treated as capital gains, the PMS activity may be considered as income from business of the assessee and taxed accordingly.
Nitesh Buddhadev is a chartered accountant and founder of Nimit Consultancy.