This article provides a comprehensive overview of Section 194K of the Income Tax Act, 1961, focusing on how tax is deducted from income related to mutual funds. It elaborates on the process of TDS deductions regarding dividends from mutual funds, as well as the provisions pertaining to income from units managed by specified companies. Additionally, it discusses Section 10(23D) of the Income Tax Act, 1961, the fundamentals of mutual funds, and insights into the Unit Trust of India. Furthermore, this article briefly explores the rules concerning suspense accounts in the context of mutual funds.
Understanding Section 194K of the Income Tax Act
Section 194K of the Income Tax Act, 1961, outlines how tax should be deducted on income earned from dividends generated by mutual funds. This particular section also addresses tax deductions on income derived from units associated with the “administrator” of the “specified undertaking” or from a “specified company.” However, income from capital gains is not included under this provision. According to this section, the tax rate is set at 10% for any income surpassing Rs. 5000/-.
When mutual fund companies issue dividends to their investors, they are responsible for withholding TDS at the mandated rates. Thus, anyone investing in mutual funds will receive their dividend only after the TDS has been deducted. For many taxpayers, mutual funds serve as a favored investment option and a supplementary income source; hence, dividend income received by investors is subject to taxation. To reclaim any tax deducted, investors can utilize Form 16A while filing their Income Tax Returns (ITR). The entity responsible for the deduction must submit Form 26Q on the TDS Reconciliation Analysis and Correction Enabling System (TRACES) Portal.
Income Generated from Mutual Fund Units
Section 194K clarifies that when any income is distributed to a resident concerning mutual fund units specified in clause (23D) of Section 10 or units from the administrator of the specified undertaking or a specified company, the individual facilitating the payment must deduct income tax at the rate of 10%. This deduction applies at the moment when the income is credited to the payee’s account, whether through cash payment or issuing a cheque or draft.
However, if the total income credited or paid during the financial year does not exceed Rs. 5000/-, no deduction will apply. Additionally, capital gains income is exempt from this provision.
Under this section, payments made to a resident concerning:
- Units of the mutual fund as outlined in Section 10(23D)
- Units administered by the specified undertaking
- Units from the specified company
The person administering the payment regarding these sources is required to withhold TDS at the rate of 10% upon crediting such income to the account of the payee or at the time of actual payment.
The terms “administrator,” “specified undertaking,” and “specified company” have specific definitions within this context, derived from The Unit Trust of India (Transfer of Undertaking and Repeal) Act, 2002.
Section 2(a) of that Act defines “administrator” as a person or body designated under Section 7 to oversee a specified undertaking. Meanwhile, Section 2(h) describes “specified company” as a company registered under The Companies Act, 2013, whose entire capital is subscribed by designated financial institutions or banks notified by the Central Government. Additionally, Section 2(i) defines “specified undertaking” as including all business operations, assets, liabilities, and properties related to the trusts and the Development Reserve Fund.
Prior to the introduction of Section 194K, dividends faced double taxation. The first tax applied when a company distributed dividends to Asset Management Companies (AMCs), and the second applied when the AMC distributed profits to unit holders.
However, following the 2020 budget, the Dividend Distribution Tax (DDT) was removed. Now, only AMCs must deduct TDS at 10% on dividends, with the stipulation that dividends must exceed Rs. 5000 in a financial year.
Initially, there was confusion regarding whether Section 194K included dividends alone or if it would also cover capital gains from mutual fund sales. To clarify, the Central Board of Direct Taxes (CBDT) stated in 2020 that TDS deductions at 10% apply solely to dividends and not to income from capital gains.
For Indian residents receiving dividend income from equity mutual funds, the payment will arrive after TDS is deducted according to Section 194K. Conversely, non-resident investors will receive their dividends after TDS deductions as per Section 195 of the Income Tax Act, 1961. The deductor will provide Form 16A as a Tax Credit Certificate, allowing the deductee to claim credit for the deducted tax when filing their tax return.
Exploring Clause (23D) of Section 10
Section 10 of the Income Tax Act, 1961, delineates various incomes that should not be included while computing a person’s overall income for the preceding year. This encompasses income from agricultural earnings, partner shares in a partnership firm that undergoes independent assessment, certain allowances, and long-term capital gains from selling equity shares of equity-based mutual funds, among others. Clause (23D) specifically allows for exemptions from income derived from mutual funds registered under the Securities and Exchange Board of India Act, 1992, or those issued by public sector banks or financial institutions.
Section 10(23D) asserts that income derived from notified mutual funds is excluded from income tax. Earnings from these funds, such as dividends or capital gains, are exempt from taxation if certain conditions are met:
- The mutual fund must be officially recognized by the government.
- The mutual fund must hold registration with SEBI.
Legal Case: UTI Mutual Fund vs. Income Tax Officer (2012)
In the case of UTI Mutual Fund vs. Income Tax Officer (2012), a petition was filed under Article 226 of the Constitution of India in response to a demand notice dated February 29, 2012, from the Income Tax Officer, requesting the petitioner to pay Rs. 9.63 crores under Section 177(3) of the Act. The dispute related to the assessment year 2009-2010. The petitioner was a trust registered as a mutual fund with SEBI, and its income was exempt from income tax under Section 10(23D). A trust known as the “India Corporate Loan Securitisation Trust, 2008” was set up by IL and FS Trust Company Ltd. to securitize a loan from Yes Bank.
The petitioner’s counsel argued that imposing such a tax was unreasonable since the trust’s income was exempt due to Section 10(23D). The court noted that the petitioner claimed that an assessment only in relation to the transferor of a revocable trust, which would permit the exclusion of the taxable income. The authority had not made any assessment against the petitioner before the court except for the communication received on March 12, 2012, which ordered payment of Rs. 9.63 crore from the trust, suggesting the petitioner was liable for the trust’s demands.
The court concluded that if an assessee has legal means to contest such demands, coercive measures by authorities would be unwarranted.
Legal Case: Bharat Bhushan Sahi vs. Department of Income Tax (2015)
In Bharat Bhushan Sahi vs. Department of Income Tax (2015), an appeal contested an order by the Commissioner of Income Tax (CIT), which classified the appellant’s income from buying and selling mutual funds as short-term capital gains instead of business income, as determined by the Assessing Officer (AO). During assessment, the appellant declared total income of Rs. 89,08,663/-, with a short-term capital gain of Rs. 89,80,665/-, and paid tax at 10% on this income.
The AO required the appellant to clarify dubious transactions and provide supporting documentation. The appellant claimed the trades were executed through Portfolio Management Services (PMS) provided by ICICI Prudential and Deutsche Bank, leading to the question of whether the profits constituted short-term capital gains or business income.
The court observed that the sale and purchase of mutual funds previously accepted as short-term capital gains were now being treated as business income without justification. The Tribunal stated it was illogical for the same type of transactions to be reclassified simply due to the year’s trading volume. The appeal was dismissed as the CIT’s classification of income remained accurate.
Understanding Mutual Funds
Mutual funds have become a favored investment choice due to their structure. Key players in this domain include fund sponsors, trustee companies, Asset Management Companies (AMCs), fund promoters, and fund managers. Mutual funds pool money from various investors, which is then invested in a variety of assets including stocks, bonds, and government securities, managed by professionals known as fund managers.
AMCs not only market the mutual funds but also manage the investments and facilitate investor transactions. They charge a fee called the expense ratio for their services, which is regulated by SEBI based on the total assets under management.
Each investor who buys shares in a mutual fund effectively acquires a share of all the underlying investments within the fund. Fund managers systematically allocate these funds across different domains based on the fund’s investment strategy.
Capital gains tax rates on mutual fund investments depend on the holding period and type of mutual fund, with the potential for TDS deductions as outlined in Section 194K. Income from dividends and capital gains remains a relevant aspect of mutual fund returns.
Types of Income from Mutual Funds
- Dividend Income: TDS is deducted on dividends paid by AMCs under the current tax regime.
- Capital Gains: Tax implications on capital gains fall on taxpayers. Long-term capital gains (LTCG) exceeding Rs. 1 lakh from equity mutual funds are taxed at 10%, while short-term capital gains (STCG) from equity-linked mutual funds subject to Securities Transaction Tax (STT) attract a 15% tax rate. Importantly, TDS is not applicable on capital gains from unitholder redemptions.
Unit Trust of India: A Historical Perspective
The Unit Trust of India (UTI), established in February 1964 under The Unit Trust of India Act, 1963, aimed to promote savings among Indian citizens and channel those resources into productive investments.
UTI operates on a unitized model, where the funds are pooled and divided into manageable units for investors. As unitholders, investors enjoy returns based on the trust’s overall performance, ensuring a secure investment avenue.
Furthermore, UTI facilitates investments for both small-scale and large-scale investors, allowing individuals to benefit from India’s industrial development.
The 2002 Act facilitates the transfer of UTI’s assets to a newly established company, ensuring its operational continuity. Section 10(35) mentions income from units handled by the administrator of the specified undertaking or a specified company will not be subjected to income tax. However, similarly to mutual funds, Section 194K stipulates a TDS deduction of 10% at payment relating to such incomes.
Suspense Account: A Temporary Solution
Suspend accounts serve as temporary holding areas for transactions that require further classification. These accounts help maintain accurate financial records while decisions on the appropriate account classification are made.
Transactions recorded in a suspense account await clarification for eventual categorization in their rightful accounts. These accounts promote organized financial books, minimizing the risk of erroneous balances in financial records.
The explanation to Section 194K states that when income is credited to a suspense account, it is treated as being credited to the payee’s account. Consequently, TDS must be deducted at 10% for any suspense account credits amounting to over Rs. 5000.
Final Thoughts
Taxation is an essential contribution by individuals and organizations to support government initiatives and infrastructure improvements. Income tax, governed by the Income Tax Act, 1961, is a significant aspect of this system.
Mutual funds, as an investment vehicle, offer an opportunity for investors to grow their wealth with a professional edge. Their liquidity allows investors to redeem their units as needed, while the expertise of fund managers serves to maximize investment returns sensibly.
Under the provisions of Section 10(23D), income derived from notified mutual funds is exempt from income tax. However, Section 194K mandates that income paid from mutual funds to residents incurs a TDS deduction of 10% on amounts exceeding Rs. 5000 a year. Furthermore, Section 10(35) offers similar tax exempt provisions for income from units managed by specific entities, with identical tax deduction obligations as outlined in Section 194K.
Frequently Asked Questions
What is Tax Deducted at Source (TDS)?
Tax Deducted at Source (TDS) refers to the government’s mechanism of collecting tax directly at the source of income, encompassing categories like salaries, commissions, and interest payments.
What is the Dividend Distribution Tax (DDT)?
The Dividend Distribution Tax (DDT) is levied on companies distributing dividends to shareholders. However, this tax was abolished in the budget of 2020.
What is an Asset Management Company (AMC)?
An Asset Management Company (AMC) manages pooled investments and invests them across a variety of assets, providing investors with extensive diversification options.
What is an Income Tax Return (ITR)?
An Income Tax Return (ITR) is a form in which taxpayers report their income and tax payments to the Income Tax Department. If an individual fails to file their returns on time, they may incur a penalty of up to Rs. 10,000 under Section 234F of the Income Tax Act, 1961.
