Budget 2020 abolished Dividend Distribution Tax (DDT) on dividends declared by mutual funds. Instead, it made dividends taxable in the hands of investors at their slab rate. For instance, someone in the 30% slab rate would pay a tax at that rate while someone in the 20% slab would pay tax at 20% on mutual fund dividends (debt or equity). This will apply from FY 2020-21. This taxation of dividends is a radically different position from what currently exists. In the existing system, equity fund dividends face a DDT of 11.65% and debt fund dividends face a DDT of 29.12% (including surcharge and cess). Once DDT is deducted, the dividend is tax free in the hands of the investor. Thus, the new tax treatment actually increases the tax burden on investors in higher tax brackets while lowering it for people in low tax brackets.
The dividend option consists of dividend payout in which the dividend is actually transferred to shareholders. It also consists of dividend reinvestment in which the dividend declared, is reinvested in the mutual fund scheme. Approximately ₹3 lakh crores out of the total AUM of open ended mutual funds of ₹23.29 lakh crore is invested in the dividend option, according to data from Morningstar. This amounts to around 12% of the total AUM. In hybrid funds, the figure is much higher at a whopping 35% of the total amount in open ended hybrid funds. This is because hybrid funds were sold aggressively after demonetization on the ground of ‘regular income’ through dividends. Mutual Funds dividends depend on the performance of the fund in question. They can only be paid from the realized profits of the mutual fund. Hence they cannot be in any way relied on for steady income. As markets became sluggish in 2019, investors grew disillusioned with hybrid funds sold on this basis. The category witnessed relentless outflows.
“Anyone in a tax bracket above 10% and who can wait for at least 1 year should not invest in the dividend plans of equity funds. Even those who cannot wait for 1 year should avoid dividend plans, if they fall in a tax bracket above 15%," said Gaurav Awasthi of IIFL Wealth. The long term capital gains tax (LTCG) in India which applies for gains in funds held for longer than 1 year is 10% (above a tax free capital gains allowance of ₹1 lakh per year).
The short term capital gains tax (STCG) in India in funds held for shorter periods is 15%. Hence investors in higher tax brackets are better off taking their returns as capital gains rather than dividends which are taxed at slab rate. “For debt funds, the same argument applies for people who can wait for 3 years and are in a tax bracket above 20%," said Awasthi. Debt mutual funds face a long term capital gains tax of 20% (after indexation) if held for more than 3 years. Budget 2020 has also proposed a 10% Tax Deducted at Source (TDS) on mutual fund dividends. Experts have pointed out that this will create compliance costs for investors in this option. “The TDS provision will also bring in the hassle of reconciliation and additional compliance for investors," said Suresh Sadagopan, founder, Ladder 7 Financial Advisories
Investment decisions should be made from a wealth creation point of view rather than mere tax arbitrage. However even from this point of view, the dividend option is less efficient because people tend to spend the dividends they receive rather than reinvest them. The dividend reinvestment option exists, but it is highly tax inefficient compared to the growth option since dividends are now fully taxable. Investors can get a regular amount from mutual funds through Systematic Withdrawal Plans (SWPs) and they do not need dividends. If you consider the tax angle, investors in all but the lowest tax brackets (zero tax or 5%) should avoid the dividend option of mutual funds for the reasons stated above. Even those in lower brackets may see their income rise with time and hence be pushed into higher tax brackets. Those who are already in the dividend option of mutual funds should consult their financial advisors. The benefits of lower taxes on capital gains in the growth option must be compared to the costs of redeeming their existing mutual fund investments in the dividend option. These can include exit load and capital gains tax, because a switch from dividend to growth is considered a taxable redemption.