UK Taxation of Indian Mutual Fund: Income vs Capital Gain | Exception Explored

The taxation of mutual fund proceeds received by UK residents from India has a significant impact on financial planning. The key question often revolves around whether to treat these proceeds as income or capital gains under UK tax laws.This determination depends on the nature of the fund, its classification under UK tax regulations, and whether specific exceptions apply.

UK Tax on Mutual Funds in India: Basic Framework

When a UK resident earns income or gains from mutual funds in India, these are subject to the UK’s rules for foreign investment taxation. Broadly, mutual funds can be classified under UK tax laws as either reporting funds or non-reporting funds, and this classification plays a pivotal role in the tax treatment:

1. Reporting Funds: Reporting funds treat gains as capital gains, making them eligible for capital gains tax (CGT) treatment and allowing the use of CGT allowances and lower tax rates.
2. Non-Reporting Funds: The government taxes proceeds from non-reporting funds as offshore income gains (OIG) at income tax rates, which are typically higher than CGT rates.

Gains from Mutual Fund in India are generally taxable in UK as Offshore Income Gain (OIG), chargeable at higher Income tax rates rather than Capital gain tax rate.  This treatment is because none of the Mutual fund in India is classified as an approved reported fund as per HMRC list published

Taxation of Indian Mutual Fund in the UK: Income vs Capital Gains | A little-known problem explored

This is a little-known problem for UK investors and may even be unfamiliar to some advisors. However, I explore this often-overlooked problem and propose alternative approaches to address it, where a non-reporting offshore mutual fund in India could potentially qualify for an exception from charge to the normal income tax rate.

The taxation of proceeds from mutual funds in India for UK residents can be complex, especially when the mutual fund is classified as a non-reporting fund under UK tax law. Non-reporting funds generally create tax obligations that differ significantly from those of reporting funds. However, HMRC guidelines may allow certain exceptions, treating the proceeds as capital gains rather than income under alternative tax treatments.

Understanding Non-Reporting Funds and Offshore Income Gains (OIG)

In the UK, mutual funds outside the UK often fall under the category of offshore funds. If authorities classify a mutual fund as a non-reporting fund, they typically treat any gain realized upon its disposal as Offshore Income Gains (OIG), making it subject to income tax rather than capital gains tax (CGT). This distinction is crucial because income tax rates for UK taxpayers are usually higher than CGT rates.

HMRC Exceptions for Non-Reporting Funds

The HMRC specifies exceptions where certain non-reporting funds can avoid treatment as OIG. According to the HMRC internal manual IFM13450 – Offshore Funds: Investors in Non-Reporting Funds: Exceptions to the Charge to Tax, such funds may qualify for capital gains tax treatment instead of income tax under defined circumstances.

This outlines scenarios where OIG may not apply. In such cases, the tax authorities can tax proceeds as capital gains instead of income, which generally benefits investors more.

One of the key exceptions is for transparent funds. These are funds where:

• The fund structure ensures transparency in operations.
• Investors have access to periodic reports disclosing the fund’s underlying holdings.
• There is a clear alignment with the regulatory and reporting standards of the jurisdiction in which the fund operates.

Deep dive navigation to relevant HMRC Exception: Offshore Transparent Funds

Under IFM13470, an “offshore fund” (meaning under s355 TIOPA 2010) may qualify as a “transparent fund” (regulation 29 of SI 2009/3001), if it meets specific criteria.

The offshore funds regime aims to prevent income from being accumulated within a fund and only taxed as a capital gain upon disposal. For funds deemed transparent for income—such as certain unit trusts and contractual funds—any income generated by the fund is attributed directly to the investor in proportion to their holdings. As a result, this income is taxed at the time it arises.

To simplify the identification of an “offshore transparent fund” and reduce unnecessary administrative burdens, specific criteria have been established. These criteria emphasize the fund’s operational transparency, the composition of its underlying assets, and the reporting available to investors:

• Limit on Chain Investments: The mutual fund’s underlying portfolio should not include more than 5% of its assets invested in other non-reporting funds, as specified in Regulation 29(2).
• Investor Reporting Requirements: The fund must provide sufficient information to its participants, enabling them to fulfil their UK tax obligations related to their share of the fund’s income, in line with Regulation 29(3).
• Proportional Taxation: Investors in transparent funds are taxed on their proportional share of the income and gains as if they directly held the underlying investments.

Application to Indian Mutual Funds

In the context of mutual funds in India, the regulatory environment, specifically for equity-based funds, may align with HMRC’s transparency requirements under certain conditions:

(A) Nature of Underlying Assets
Given the fact that investor can’t control, change or switch the composition of underlying assets portfolio of Mutual fund, it is essential to evaluate the fund’s type, structure at the beginning stage, analyse about the underlying assets that should not be further more that 5% in non-reporting fund.
I recommend to our clients (based on their risk appetite) consider investing in mutual funds with ‘dividend scheme’ with portfolios composed entirely of equity shares listed and traded on a public exchange. This approach minimizes potential future complications of higher income tax rate in UK at maturity.

Another type of equity mutual fund in India operates known as a ‘Growth Scheme,’ where any periodic income generated from the equity units held is reinvested into the fund. In such cases, the mutual fund trust must transparently report the amount of income earned and reinvested into the pool.
A mutual fund with a portfolio consistently comprising 100% publicly traded equity assets throughout its lifecycle aligns well with transparency requirements.

(B) Periodic Reporting and Transparency
The mutual fund in India must publish regular, transparent reports detailing its performance and underlying assets including any interim income generated and further reinvested pools. There is a specific compliance with SEBI Circular No. SEBI/HO/IMD/DF2/CIR/P/2018/92 (dated June 5, 2018) ensures adherence to high standards of disclosure and transparency.

• Historical Data Disclosure of NAV from start date till sale date
• Providing annual audited report with detailed schedules
• Sharing portfolio disclosure of underlying assets
• Members lists are update with centralised KYC and reported under CRS worldwide of Income tax

(C) Regulatory Oversight
Funds regulated under SEBI (Securities and Exchange Board of India) and compliant with local laws may strengthen the case for them being treated as transparent fund under HMRC guidelines.

Implications for UK Tax Residents

If an Indian mutual fund can meet the criteria of a transparent fund, proceeds from such funds may be treated as capital gains under UK tax rules, rather than offshore income gains. This treatment could provide significant tax advantages, including:

• Lower tax rates: Capital gains tax rates (18% or 24% or 28%, depending on income levels and fund assets) are typically lower than income tax rates (up to 45% for higher earners).
• Access to the annual CGT exemption allowance.

However, for funds that do not meet these criteria, proceeds are likely to be treated as offshore income and taxed at higher income tax rates.

Challenges and Considerations

(A) Classification as a Transparent Fund
Although compliance with SEBI regulations enhances the fund’s transparency, the ultimate classification as a transparent fund depends on whether HMRC recognizes the offshore non-reporting fund exemption under IFM13470 guidelines.

(B) Periodic Reporting Compliance
Investors must ensure that the mutual fund’s reporting meets UK standards in addition to SEBI requirements. The availability of detailed disclosures is critical to qualify for the exception. You could ascertain regular historical reporting make it available for our information as and when is required.

• historical data portfolio assets,
• structure of organisation and
• NAV per Unit since inception till closure

(C) Professional Advice
Taxation rules for offshore investments are complex and subject to interpretation. Consulting a tax advisor with expertise in both UK and Indian tax regulations is crucial to avoid potential pitfalls.

Key Takeaways

The treatment of proceeds from Indian mutual funds as income or capital gains in the UK depends on the fund’s classification under HMRC guidelines. If the mutual fund meets the transparency requirements outlined in IFM13470, it may qualify as a transparent fund, allowing for the application of capital gains tax. Factors such as the fund’s equity composition, regulatory compliance, and periodic reporting play a critical role in determining its tax treatment.

This distinction is particularly relevant for UK residents investing in Indian equity-based mutual funds. By proactively ensuring compliance with transparency standards, investors may optimize their tax liabilities and benefit from more favourable CGT treatment. As always, consulting with a tax professional like us is recommended to ensure compliance and optimal tax planning.

Disclaimer

This article reflects the opinion of a practicing member and is intended for informational purposes only. It should not be considered tax advice. Readers are strongly encouraged to consult a qualified tax advisor for personalized advice before taking any action based on the content of this article.