(Courtesy HDFC Securities)
In the FY14 Budget, the Finance Minister has proposed to increase the Dividend Distribution Tax (DDT) on Debt Mutual Funds (other than liquid and money market funds on which the DDT was already 25%) from 12.5% to 25% (plus surcharge and cess) for individuals and HUFs. The hike is proposed to provide uniform taxation for all types of funds other than equity oriented mutual funds in the Mutual Fund Industry.
This amendment will take effect from 1st June, 2013.
Classification of Funds: As far as tax implications on Indian mutual funds are concerned, they are classified as three parts as ‘Equity oriented Funds’, ‘Liquid and money market Funds’ and ‘Debt Funds other than Liquid Funds’. In ‘Equity Oriented Funds’, the categories coming under are Equity Diversified, Equity Sector, Hybrid - Equity Oriented (more than 65% equity) and Arbitrage Funds. Liquid Funds and Liquid ETF are coming under ‘Liquid Funds’ while Ultra Short Term Funds, Floating Rate Funds, Short Term Income, Dynamic Income, Income Funds, Gilt Funds, Fund of Funds, Hybrid - Debt Oriented (less than 65% equity), MIP, FMPs are coming under ‘Debt Funds other than Liquid Funds’.
Tax on distributed income: Given the tax provision on the distributed income, fund houses pay taxes on the dividend distributed to the investors. Fund houses deduct DDT from the Dividend. So the dividends are tax free in the hands of investors.
Existing tax structure on DDT: As per the existing structure, there is no tax levied on the dividend distributed by Equity oriented mutual fund schemes for any investors. But, Liquid and money market Funds are liable to pay the DDT of 25% (plus surcharge and cess) for retail investors while the funds other than Liquid and money market funds are liable to pay DDT of 12.5% (plus surcharge and cess). For institutions and corporates, DDT on Equity funds is nil while 30% (plus surcharge and cess) in case of the dividends from the investments in Liquid Funds and debt funds other than Liquid funds.
Proposed Structure: From June 01, 2013 onwards, retail investors who invest in all debt funds (other than equity funds) are liable to pay DDT of 25% (plus surcharge and cess) on the dividend income. The DDT for corporate investors has been kept unchanged at 30% (plus surcharge and cess).
Increase in Surcharge: Further, the surcharge on Dividend Distribution Tax for all mutual fund schemes has gone up from 5% to 10%. Impact: This move will make dividend options in Debt Mutual Funds unattractive for retail investors. Because the net post tax return in the hands of the investors from dividend plans would be lower as the DDT charged on the debt funds has been increased from 12.5% to 25% (plus surcharge and cess). Meanwhile, the Growth options in the Debt Mutual Funds will become attractive for retail investors who redeem the investments after a year, taking advantage of long term capital gains.
Capital Gain: Since the DDT is applicable for Dividend plans, Capital Gains tax is applicable to Growth plans. The gains from the debt mutual scheme (growth option) are taxed depending on the period the investments in the mutual funds are kept. If the debt mutual fund units are redeemed after a year, then the gains thereon are liable to Long Term Capital Gain tax while the proceeds from the investments which redeemed before one year are taxed as Short Term Capital Gain. For long term capital gains in debt funds, the investor has to pay the tax @ lesser of 10% without indexation or 20% with indexation; (plus education cess). Short Term Capital Gain is taxed as per the normal slab of the investors.
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The below tables summaries the changes proposed in the Union Budget on DDT. For Retail Investors (Individuals and HUFs):
For Institutions and Corporates:
| Classification | Categories | Existing | Proposed (From June 01, 2013) |
| Equity Funds | Equity Diversified, Equity Sector, Hybrid - Equity Oriented (more than 65% equity), Arbitrage Funds | NIL | NIL |
| Liquid Funds | Liquid Funds and, Liquid ETF | 32.445% = 30%+ 5% (SurCharges) + 3% (Cess) | 33.99% = 30%+ 10% (Sur Charges) +3% (Cess) |
| Debt Funds other than Liquid Funds | Ultra Short Term Funds,Floating Rate Funds, Short Term Income,Dynamic Income, Income Funds and Gilt Funds.Hybrid - Debt Oriented (less than 65% equity), MIP,FMPs, | 32.445% = 30%+ 5% (SurCharges) + 3% (Cess) | 33.99% = 30%+ 10% (Sur Charges) +3% (Cess) |
Despite the increase in the DDT, Dividend plans in the Debt schemes are still attractive for investors who fall under the higher tax slab of 30%. They still give higher post-tax returns than similar products such as bank fixed deposits. In the Dividend option of debt funds, an investor has to pay the tax of 28.325% (over short term) while in Bank Fixed deposit, he has to pay 30.9%. Growth option in Debt Mutual Funds looks even more attractive if the units are redeemed after a year. Gains thereon are liable to be taxed as Long Term Capital Gains @ lesser of 10% without indexation or 20% with indexation; (plus education cess). Hence, the growth option of Debt funds continues to remain the best bet for anyone who wants to accumulate wealth to meet long-term goals.
Apparently, the categories MIP and Ultra Short Term Funds will be affected much due to the move. Investors who depend on dividend income preferably have invested with MIP categories (in most of the cases). And, the Ultra Short Term category is treated as substitute to liquid funds for their tax efficiencies (hence, both are having similar investment strategy). We arrive at some feasible solutions based on the objectives of the investors who wish to allocate into debt funds.
1. Investors who wish to park their idle money:
Over short term (holding overnight to a year): investors who belong to 30% tax bracket may consider investing in Dividend options of Liquid, Ultra Short term and Short Term Income Funds. They are liable to pay the tax of 28.325% on dividend income. On the other hand, 30.9% of tax has to be paid if Growth option is chosen.
Over Long Term (more than one year): Growth option of Liquid, Ultra Short term and Short Term Income Funds can be the better choice. They are liable to pay Long Term Capital Gains to the lesser of 10.3% without indexation or 20.6% with indexation (plus education cess) while redeeming the units after a year or so.
2. Investors who wish to invest for Short Term:
Dividend options of Ultra Short term and Short Term Income Funds can be the better bets for investors who wish to invest in debt funds over short term. They have to pay DDT of 28.325% on dividend income. On the other hand, they would have pay 30.9% if they chose Growth option.
Effective Post tax yield in Short term investments (for the redemption of within a year):
| Particular | Fixed Deposit | Mutual Fund | |
| Growth Option | Dividend Option | ||
| Assumed rate of return from the investment (%) p.a | 9% | 9% | 9% |
| Income tax rate | 30.90% | 30.90% | NA |
| Dividend Distribution Tax | NA | NA | 28.33% |
| Effective post tax yields | 6.22% | 6.22% | 6.45% |
3. Investors who wish to invest for Long Term:
Growth option of Ultra Short term and Short Term Income Funds can be the better choice for low risk appetite investors. Investors having high risk profile can consider Income and Gilt funds also. If they want marginal equity allocation in their portfolio, then MIP may be the better choice. In all the above cases, investors are liable to pay Long Term Capital Gains to the lesser of 10.3% without indexation or 20.6% with indexation (plus education cess) while redeeming the units after a year or so.
Effective Post tax yield in Long term investments (for the redemption of after a year):
| Particular | Fixed Deposit | Mutual Fund | |
| Growth Option | Dividend | ||
| Option | |||
| Assumed rate of return from the investment (%) p.a | 9% | 9% | 9% |
| Income tax rate | 30.90% | 10.3% | NA |
| Dividend Distribution Tax | NA | NA | 28.33% |
| Effective post tax yields (lumpsum withdrawal after a year) | 6.22% | 8.07% | 6.45% |
4. Investors who wish to have regular income:
Investors who need regular income can consider investing in Liquid, Ultra Short Term, Short Term, Income, Gilt and MIPs mutual fund categories by opting Systematic Withdrawal Plan (SWP). This facility allows investors to receive certain amount in regular intervals. In short, SWP is reverse of Systematic Investment Plan (SIP). In SIP you invest a fixed sum every month for a predetermined time period. Under SWP you withdraw a fixed sum for specified time period or till your corpus becomes zero. SWP allows investors to withdraw from the funds after one year from the date of allotment of the units.
Investors looking for income at periodical intervals usually invest in these funds. Often, a systematic withdrawal plan is used to fund expenses during retirement.
Types of SWPs: Under SWP, withdrawals can be fixed or variable amounts at regular intervals. These withdrawals can be made on a monthly, quarterly, semi-annual or annual schedule. The holder of the plan may choose withdrawal intervals based on his or her commitments and needs. SWP is usually available in two options:
Fixed Withdrawal: Under this you specify amount you wish to withdraw from your investment on a monthly/quarterly basis. Appreciation Withdrawal: Under this you can withdraw your appreciated amount on a monthly/quarterly basis.
SWP is tax efficient option in comparison to other options such as Bank and Corporate Fixed Deposits. The tax liability in SWP is lower than that of bank FDs (with the caveat that withdrawals can begin only after a year to avail concessional tax treatment). The applicable tax rate (for the investor who belongs to 30% tax bracket) on the income from SWP is 10.3% which is lower than the applicable tax rate of 30.9% in Bank FDs. A comparative study in the monthly withdrawals from the investments in debt fund (through SWP) and Bank FD for the period of three years clearly shows that SWP is more tax efficient than Bank FDs. The effective post tax yield, an investor gets from SWP option is close to 8.02% while from the Bank FD is around 6.40%. Further, no TDS is applicable in SWP withdrawals but it is applicable in Bank FDs for interest above a certain limit.
Conclusion: Investors can thus take necessary action to control the impact of the above change in tax liability by reviewing their investments in the background of their liquidity, return needs, risk profiles and redeem/switch their investments/plans/options.
