10.7 Financial Transactions with Mutual Funds
Key Takeaways
- The financial transactions are purchase, additional purchase, redemption and switch.
- A switch is a redemption from one scheme and a purchase into another, so it is a taxable event.
- Redemption may be requested by amount or by number of units, and follows first-in, first-out.
- Minimum amounts for purchase, additional purchase and redemption are stated in the scheme documents.
- Units under lock-in, lien or pledge cannot be redeemed until the restriction is released.
The Four Financial Transactions
| Transaction | Effect |
|---|---|
| Purchase | First investment in a scheme, creating a folio or adding a scheme to one |
| Additional purchase | Further investment into a scheme already held |
| Redemption | Units surrendered to the fund for cash |
| Switch | Redemption from one scheme and simultaneous purchase into another |
A transaction is financial when it changes the value of the holding. Changes of address, bank mandate or nomination are non-financial and are covered in section 10.11.
Purchase and Additional Purchase
Minimum amounts are stated in the scheme documents and vary by scheme, typically with a lower minimum for additional purchases than for the first investment, and a lower one still for systematic instalments.
Processing requires:
- Application received at an Official Point of Acceptance within the cut-off time
- Funds realised and available for utilisation
- KYC complete and PAN valid
Units are then allotted at the applicable NAV, net of stamp duty.
Redemption
A redemption request may be made in either of two ways:
| Basis | How it works |
|---|---|
| By amount | "Redeem INR 2,00,000" — the RTA computes the units needed at the applicable NAV |
| By units | "Redeem 3,000 units" — the amount depends on the applicable NAV |
| All units | Full redemption of the holding in that scheme |
Requesting by amount carries a subtlety worth knowing: because the applicable NAV is not known when the request is submitted, the exact number of units redeemed is determined afterwards. An investor who needs a precise sum should redeem by amount; one who wants to retain a precise unit holding should redeem by units.
First-in, first-out
Units are redeemed on a FIFO basis, oldest first. This determines:
- Whether exit load applies, since load depends on each parcel's holding period
- Whether gains are short-term or long-term, since holding period is measured per parcel
- The cost of acquisition used in computing the gain
For a long-running SIP this works in the investor's favour, because the oldest instalments — most likely to qualify as long-term and to be free of exit load — are redeemed first.
Units that cannot be redeemed
- Units under statutory lock-in, such as ELSS within three years of each instalment
- Units under lien or pledge, until the lender releases them
- Units in a folio frozen for documentation, such as a minor attaining majority
- Units in a segregated portfolio, which are not redeemable from the fund at all
- Units where KYC is on hold
Switch
A switch is a single instruction executing two transactions:
Switch out of Scheme A = Redemption from Scheme A
Switch into Scheme B = Purchase into Scheme B
The consequences follow from that, and every one of them surprises investors:
| Consequence | Detail |
|---|---|
| Capital gains tax | Arises on the switch-out leg, exactly as on a redemption |
| Exit load | Applies to the switch-out leg if within the load period |
| Stamp duty | 0.005% on the switch-in leg, since units are issued |
| Fresh holding period | Begins for the new units, affecting future long-term treatment |
| Cut-off timing | Applies to both legs |
Switching is available between schemes of the same fund house. Moving between fund houses requires a redemption and a separate fresh purchase, during which the money is out of the market.
Common switch scenarios:
- Regular plan to direct plan — a taxable redemption, which must be stated before executing
- Growth to IDCW or the reverse — also a taxable redemption
- Equity to debt as a goal approaches — the correct use of a switch, and the tax cost is simply part of the decision
- Between schemes for performance reasons — legitimate occasionally, and the pattern AMC due diligence examines when it becomes habitual
Suspension of Transactions
A scheme may restrict or suspend redemption only in exceptional circumstances and subject to strict conditions — market-wide closure, a systemic crisis or operational events beyond control. Restrictions may be imposed only for a limited period with trustee approval and disclosure to SEBI, and small redemption requests up to a prescribed threshold must continue to be honoured. Suspension is not available to manage ordinary redemption pressure.
What a Distributor Should Confirm Before Any Redemption or Switch
- Is any part of the holding under lock-in, lien or pledge?
- Will exit load apply, and on how much of the holding?
- What are the capital gains consequences, and would waiting change the treatment?
- Are the bank details in the folio current?
- For a switch, has the investor understood it is a taxable redemption?
Asking these five questions takes two minutes and prevents most post-transaction complaints.
An investor switches from an equity scheme to a debt scheme within the same fund house. Which set of consequences is correct?
An investor with a five-year monthly SIP redeems part of the holding. Which units are redeemed and why does it matter?
Under what circumstances may a scheme restrict redemption?