The Tax Efficiency of ETFs
ETFs or Exchange Traded Funds provide a cost-efficient way for you to add
diversity to your portfolios. The lower operational costs with the potential to invest in a wide range of stocks
have earned ETFs a place in portfolios of both seasoned and novice investors. But ETFs also have another potential
benefit – tax efficiency.
How are ETFs Taxed?
ETFs can be traded on the stock exchange like individual shares. You can take advantage
of changes in the selling price throughout business hours and sell your ETF units as and when you hope to make a
profit. The change in price is determined by the supply and demand for the ETF units. When demand goes up, so does
the price and vice versa. The profit earned on ETFs is called capital gains.
Capital gains earned on ETFs are taxed similarly to capital gains earned on traditional mutual funds. For the
purpose of taxation, let us divide ETFs into two categories- equity based ETFs and others as non-equity ETFs which
includes gold ETF and debt ETFs. Equity ETF are those where the investible fund remains invested in listed equity
shares of domestic companies, basis the scheme’s strategy. Here too, based on the holding period, one can further
divide investments as long term and short term. Long term investments are the ones that are held for more than 1
year and short term investments, less than one year. In case of equity ETF, capital gains made on short term is
taxed at flat 15% and in case of long term the gains made from ETFs and listed equity shares taken together during a
year are taxed at a flat rate of 10% after an initial exemption of one lakhs rupees.
Profits on some non-equity ETFs get taxed as long term if held for more than 36 months else it gets taxed as
short-term capital gain. Short term capital gains on non-equity ETF is treated as regular income and is taxed at the
regular applicable rates. However, when it comes to long term capital gains, you get the benefit of indexation. An
indexed long term capital gain is nothing but the difference between indexed cost and sale price. Such indexed long
term capital gains are taxed at flat 20%.
Please note: Unlike long term capital gains on equity ETF where you get an initial exemption of one lakhs, the long
term capital gains on non-equity ETFs do not enjoy any initial exemption.
You can claim exemption against any long-term capital gains tax liability if you invest the net sale proceeds of
such capital asset for buying a residential house within two years or get a residential house constructed within
three years from the date of sale of such asset. One can claim this exemption even if you have already purchased a
house within one year prior to sale of long-term capital gains asset.
How can ETFs be More Tax Efficient?
ETFs can be more tax-efficient that traditional mutual funds in a few
cases:
Comparatively low returns: ETFs track a benchmark index on the stock markets and replicate its stock profile
exactly. If a stock is in the benchmark, it will be there in the ETF in the same proportion. ETFs are structured so
that they match the performance of the benchmark and don’t actively try to beat it like some actively managed funds.
Owing to the way ETFs operate, they generally provide lower returns than some other types of mutual funds.
Therefore, the overall tax liability of ETFs is also lower.
Setting off losses: As mentioned earlier, ETFs are traded on the stock exchange. While in most cases
investors aim to make a profit from this trading, there might also be cases when they have to sell their units at a
loss, i.e., at a lower price than what they bought them for. This is termed as capital loss which can help lower tax
liability. Here’s how setting off losses to lower tax liability works:
• Capital losses need to be set off only against capital gains (not any other income).
• Long term capital loss can be set off against long term capital gains of that year.
• Short term capital loss on the other hand can be set off against both short-term and long-term capital
gains.
• Both short-term and long-term capital losses can be carried forward for up to eight consecutive assessment years
after incurring the loss in case there are no capital gains to set them off against.
Creation units: While this might not typically happen in an emerging market like India, there may be cases
where fund managers prevent inflows of cash into an ETF from exposing investors to capital gains. This cash inflow
is adjusted by creating or redeeming creation units which are a basket of asset that replicate the ETF investment in
its entirety. This works out as more tax efficient for the investors as compared to having an additional taxable
event through ETFs.
ETFs are structure in a way that ensure they provide modest returns while maintaining lower operational costs. This
structure has the potential to add tax-efficiency to the investors portfolio without compromising on diversification
and equity exposure.
An investor education initiative
An investor education initiative
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more about the process to complete a
one-time Know Your Customer (KYC) requirement to invest in Mutual Funds. Investors should only deal with registered
Mutual Funds, details of which can be verified on the SEBI website https://www.sebi.gov.in/intermediaries.html For any
queries, complaints & grievance redressal, investors may reach out to the AMCs and / or Investor Relations
Officers. Additionally, investors may also lodge complaints on https://scores.gov.in if they are unsatisfied with the resolutions given by
AMCs. SCORES portal facilitates you to lodge your complaint online with SEBI and subsequently view its status.
Mutual fund investments are subject to market risks, read all scheme related documents carefully.
