I have opted for Dividend reinvestment option in case of a Liquid Fund. Is there any tax liability on the appreciation in the principal amount at the time of redemption?
Will the case be different in case it is Equity fund rather than a Liquid fund?
Let us understand the basic principle first. From a tax point of view, taking a dividend reinvestment option is no different from receiving the dividend in you bank account and then making a fresh investment of the same amount. The dividend received will be taxed like any other dividend (Dividend Distribution Tax or DDT) and resulting purchase of fresh units will be treated like any other fresh capital investment. Any capital gains that you realise when you sell will be treated as long-term or short-term depending on the period of investment. Therefore, what you refer to as principal amount is not a single principal amount but a separate principal amount for each individual dividend reinvestment. Each one of these individual investments will therefore become long-term on a separate date 365 days after it was invested. This is a basic principle that is applicable to all types of funds.
In the liquid fund case, there will definitely be a tax liability on the capital appreciation on the principal amount at the time of redemption. If you redeem the units within 365 days from the date of purchase, then any short-term gains would be added to your income and taxed as per your tax slab, whereas if the redemption is made after 365 days from the date of purchase one is liable to pay a Long-term Capital Gains Tax. Dividends are irrelevant to capital gains tax.
The same basic principle applies to equity funds also but the actual tax paid will be different because in the case of equity (whether funds are shares) neither dividends nor long-term capital gains are taxable. Only short-term capital gains tax needs to be paid for equity.