The Tax Efficiency of ETFs (2024)

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 ETFs 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 investments are taxed at flat 15% and in case of long-term ones, 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 Rs. 1 lakh.

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 Rs. 1 lakh, 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. In most cases, investors aim to make a profit from this trading, but 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 structured 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 by ICICI Prudential Mutual Fund

Visit www.icicipruamc.com/note to know 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 (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.

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