What are ETFs?
ETF is the abbreviation used for Exchange Traded Funds. This is a unique investment product that is relatively new to the Indian stock markets. These are funds that are formed out of a basket or a pool of stocks or securities. These funds track the underlying index for their performance. Such tracking may be subject to some errors or deviations that are known as tracking errors. The funds having lower tracking error and expense ratio are preferred by the investors for making investments in ETFs
Read More – How to Invest in Index funds in India?
What are Index Funds?
Index funds are also a basket of individual securities. These funds are similar to mutual funds in their nature of formation but their performance or returns are dependent on the underlying index that they track. Like ETFs, these returns are also prone to tracking errors and are also passively managed funds. Investment in index funds is also considered to be safer as well as cost-effective as compared to mutual funds.
Taxation of ETFs
Taxation is one of the crucial factors on the income earned from ETFs. Investors can earn income in two forms from ETFs namely, dividend income and capital gains. The tax liability for the income earned from ETFs is mentioned below.
- Tax on dividends
The dividends earned from ETFs were earlier taxed in the hands of the company issuing such dividends. Such dividends were subject to DDT (Dividend Distribution Tax) at the rate of 15% excluding the applicable cess. However, from the financial year 20-21, the dividend earned from ETFs is taxed at the hands of the investors. This income is subject to tax at the applicable income tax slab rates for the investors.
- Tax on capital gains
Capital gains are levied at the time of sale or redemption of units of the ETFs. The profit earned through such transactions is subject to the levy of capital gains. Such capital gains are dependent on the type of ETF as well as the period of holding. The tax structure for capital gains is tabled below.
| Types of ETFs | Time frame for Short term capital gains | Tax rate | Time frame for Long term capital gains | Tax rate |
| Equity ETFs | Maximum 12 months | 15% (plus Cess) under section 111A | 12 months and more | 10% (plus cess) on gains exceeding Rs. 1,00,000 |
| Other ETFs (Debt ETFs, Gold ETFs, International ETFs) | Maximum 36 months | Slab rates | 36 months and more | 20% with the benefit of indexation |
Taxation of Index funds
Index funds are also subject to taxation on account of capital gains as well dividends earned. The dividend earned on the index funds is included in the taxable income of the investor. Such income is then taxed at the applicable slab rates.
The rate of taxation for capital gains, on the other hand, is dependent on the period of holding of the fund. This makes it an effective tax tool as capital gains come into the picture only when the units of the fund are redeemed. The details of the taxes levied on the investors of index funds are mentioned below.
| Particulars | Time frame for Short term capital gains | Tax rate | Time frame for long term capital gains | Tax rate |
| Index Funds | Maximum 12 months | 15% (plus Cess) under section 111A | 12 months and more | 10% (pluss cess) on gains exceeding Rs. 1,00,000 (This is including all your direct equity and equity mutual funds) |
Impact of Double Taxation Avoidance Agreement (DTAA)
Double Taxation Avoidance Agreement (DTAA) is an agreement between two countries to avoid double taxation of income or capital gains. DTAA between India and other countries can impact the taxation of index funds and ETFs in India. For example, if an Indian investor invests in an index fund or ETF domiciled in a country with which India has a DTAA, the investor may be eligible for a tax credit on the dividends or capital gains earned from the investment. This can help to reduce the overall tax liability on the investment.
Here are some of the key impacts of DTAA on index funds and ETFs in India:
- Reduced tax liability: DTAA can help to reduce the overall tax liability on index funds and ETFs by providing tax credits on dividends or capital gains earned from investments in countries with which India has a DTAA.
- Increased investment options: DTAA can increase the investment options available to Indian investors by making it easier to invest in index funds and ETFs domiciled in countries with which India has a DTAA.
- Improved transparency: DTAA can improve transparency by providing information on the tax treatment of index funds and ETFs domiciled in countries with which India has a DTAA.
Overall, DTAA can have a positive impact on the taxation of index funds and ETFs in India by reducing the overall tax liability on investments, increasing the investment options available to Indian investors, and improving transparency.
Conclusion
ETFs and Index funds are relatively new as investment instruments in the Indian market. These products have gradually made their place in the investor’s portfolio over the years due to increased investor awareness and their multiple benefits over other investment products like mutual funds. Both these products have tax advantages and can be used as an effective investment instrument for gaining good returns at lesser tax liability.
Frequently Asked Questions
No. Equity Index funds do not have the benefit of indexation in case of long-term capital gains.
Yes. Dividends earned through both funds are taxable at the hands of the investors. Such income is included in the taxable income of the investor and taxed at the slab rates that are applicable for each financial year.
The expense ratio of ETFs is relatively lower as compared to the expense ratio of index funds. This gives it an edge over the index funds.
One of the fundamental differences between ETFs and index funds is the former’s ability to be traded in the open market like any other stocks. This is also considered to be the basic advantage of ETFs over index funds.
