How are ETFs Taxed in India - Taxation of Income from ETFs

An exchange-traded fund (ETF) is a marketable product that tracks an index (like BSE Sensex or the CNX Nifty), a commodity (like gold or silver) bonds, or a basket of assets.

When you buy an ETF, you are purchasing shares/units in a portfolio that replicates the yield and return of its original index. ETFs vary from index funds in a way that the latter do not attempt to outperform their respective index, but rather replicate its performance.

There are two ways for investors to make money by investing in ETFs:

Through Dividends: Many ETFs hold a basket of stocks that pay dividends to their shareholders. By investing in these dividend-focused ETFs, investors can earn income in the form of regular dividend payments. These dividends are typically distributed periodically, such as quarterly or annually, and can provide investors with a steady stream of income.

Dividend ETFs often focus on companies with a history of stable earnings and consistent dividend payouts, making them attractive for income-oriented investors seeking to supplement their investment returns.

Through Capital Gains: Investors can also earn money through capital gains by investing in ETFs. Capital gains occur when the price of the ETF increases, allowing investors to sell their shares at a higher price than what they initially paid.

Investors can realise capital gains by selling their ETF shares at a profit, either partially or entirely, depending on their investment goals and risk tolerance.

Tax Structure for Dividend Income: Earlier, dividends were subject to DDT (Dividend Distribution Tax) in the hands of the company issuing the dividend. However, from FY 2020-21, dividend income received from ETFs is added to the investor's annual income and taxed according to the applicable slab rates.

Tax Structure for Capital Gains: As mentioned earlier, the ETF capital gains tax arises when the ETF units are sold or redeemed. The tax structure differs depending on the type of ETF and the duration for which it is held.

• These exchange-traded funds primarily invest in stocks and related financial instruments. The tax structure for equity ETFs is similar to that of equity stocks.

• Both long-term and short-term capital gains tax are applicable depending on the duration of holding the ETF. Hence, if gains are earned from selling equities that were kept for less than a year, they are deemed short-term capital gains. Similarly, gains are regarded as long-term gains if they are held for more than one year.

• According to section 112A of the Income Tax Act, all long-term gains up to ₹1 lakh are tax deductible, and any sum over 1 lakh that is not subject to indexation benefits would be subject to 10% tax.

• The Income Tax Act's section 111A states that short-term capital gains are subject to a 15% tax rate, surcharge, and other cesses as necessary.

The taxation of gold, debt, international and other ETFs is comparable. However, in this instance, both the short-term and long-term capital gains are defined.

If the gains from the sale of these ETFs (held for less than 3 years), it is referred to as short-term gains. Similarly, gains on capital are regarded as long-term gains if they are kept for more than 3 years.

• In addition to indexation benefits, the tax applicable is 20% for long-term capital gains from gold, debt, or foreign ETFs.

• The amount of any short-term capital gains will be included in the investor's yearly income and subject to income tax as per the slab rate.

In conclusion, understanding the taxation of Exchange Traded Funds in India is crucial. Investors need to be aware of the taxation rules applicable to ETFs, which primarily revolve around capital gains and dividends. Long-term capital gains tax for equity ETFs is applicable on gains realised after holding ETF units for more than one year and is subject to indexation benefits. On the other hand, short-term capital gains tax is levied on profits from the sale of ETF units held for one year or less, taxed at the individual's applicable income tax slab rate.

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