Taxation of Exchange-Traded Funds (ETFs) in India

Investors find Exchange-Traded Funds (ETFs) appealing for their diversification, low cost, growth potential and trading flexibility. However, one aspect demanding careful attention is how gains, dividends, and redemptions are taxed. In India, taxation rules vary based on the asset class an ETF invests in (equities, debt, gold, etc.), influencing an investor’s net return.

Understanding ETF taxation in India can aid in tax planning and help investors earn better post-tax returns. This article explores the main tax considerations—ranging from capital gains categories to dividend distribution—for individuals looking to optimise their ETF strategies.

• Table of contents

1. What is ETF taxation
2. Difference between short-term vs. long-term capital gains on ETFs
3. Dividend distribution tax on ETFs
4. How to save tax on ETFs

What is ETF taxation

ETFs operate similarly to mutual funds in terms of pooling investor money to purchase a basket of securities. However, the way an ETF is classified (equity-oriented, debt-oriented, or commodity-based) determines its tax treatment.

• Classification matters
  • Equity ETFs: Those that invest at least 65% of their total assets in equities.
  • Non-equity ETFs: Covers debt ETFs, gold ETFs, and other commodity or international ETFs.
• Primary tax streams
  • Capital gains tax: Triggered when you sell or redeem ETF units at a profit.
  • Dividend tax: Relevant if the ETF pays dividends to unit holders (though many ETFs reinvest earnings, some still offer dividends).
• NAV and market transactions
  • Unlike mutual funds – where redemptions happen at day-end Net Asset Value – ETFs trade on exchanges in real-time. For tax purposes, however, gains or losses remain governed by the same capital gains principles as mutual funds.

Difference between short-term vs. long-term capital gains on ETFs

Capital gains tax on ETFs depends on whether your profit falls under short-term or long-term brackets. The holding period thresholds differ for equity vs. non-equity ETFs.

• Equity-oriented ETFs
  • Short-term: For equity-oriented ETFs held for one year or less, gains are classified as short-term. Gains realised before July 23, 2024, are taxed at 15%. For gains on or after this date, the tax rate is 20%.
  • Long-term: For holdings exceeding one year, gains are considered long-term. Gains exceeding Rs. 1.25 lakh realised before July 23, 2024, are taxed at 10%. For gains on or after this date, the tax rate is 12.5%.
• Non-equity (debt or commodity) ETFs
  • Short-term: For non-equity, gains are short-term regardless of the holding period. These gains are added to the investor's income and taxed according to the applicable income tax slab rates.

Dividend distribution tax on ETFs

Although many ETFs follow growth-oriented strategies—reinvesting profits to lift the NAV—some do declare periodic dividends.

• Prior to FY 2020-21: Dividends from ETFs were subject to a Dividend Distribution Tax (DDT) of 15%, deducted at the source by the company.
• From FY 2020-21 onwards: DDT was abolished. Dividends are now added to the investor's annual income and taxed as per their respective income tax slab rates. Additionally, a 10% TDS is deducted by the AMC for dividends higher than Rs. 5,000 in a financial year.

How to save tax on ETFs

Some tax-saving strategies for ETF investors are:

• Pick the right holding period: If you hold equity ETFs for over 12 months, you shift from a 20% STCG rate to a 12.5% LTCG rate.
• Harvesting losses: If some of your ETFs record losses, consider booking them to offset gains in other assets. This approach—termed “tax-loss harvesting”—can reduce overall tax liability, albeit requiring careful timing and portfolio rebalancing.
• Holding through market cycles: For cost-averaging and potential tax efficiency, consistently investing and holding long term can lower the frequency of STCG events, especially for equity-oriented ETFs.

Conclusion

While ETFs offer liquidity and diversification akin to mutual funds, it’s crucial to recognise their unique tax angles—particularly around classification (equity vs. non-equity) and dividend policy. Those seeking a simpler approach to market exposure often find that mutual funds and ETFs complement one another. For instance, an equity mutual fund for active management plus an index ETF for passive, cost-effective exposure can form a balanced portfolio. Ultimately, understanding the tax implications on ETFs—and aligning them with your broader strategy—can lead to more confident investing and better net results.

FAQs:

How are ETFs taxed in India?

ETFs in India are taxed based on the type (equity or non-equity), holding period, and nature of income (dividends or capital gains). Tax rates and classifications differ accordingly.

What is the difference between short-term and long-term capital gains tax on ETFs?

• Equity-Oriented ETFs:
  • Short-Term: Held for one year or less; taxed at 20% for sales on or after July 23, 2024.
  • Long-Term: Held for more than one year; gains above Rs. 1.25 lakh taxed at 12.5% for sales on or after July 23, 2024.
• Non-Equity ETFs:
  • Short-Term: Taxed as per income tax slab rates regardless of the holding period.

Are dividends from ETFs taxable?

Yes, dividends from ETFs are taxable. From FY 2020-21, dividends are added to the investor's income and taxed according to the applicable income tax slab rates.

How can investors reduce their tax liability on ETF investments?

Investors can minimise ETF-related taxes by:
For Equity-Oriented ETFs, holding investments beyond one year can benefit you by lowering long-term capital gains tax rates. Using capital losses from other investments to offset gains can reduce taxable income. Combining these strategies can help optimise after-tax returns.

Mutual Fund investments are subject to market risks, read all scheme-related documents carefully.
This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.