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No Dividend Distribution Tax for Debt Funds?

The Direct Tax Code has no DDT for debt or non-equity funds. Currently, for liquid funds, dividends are taxed at 25% plus the surcharge and cess, which adds up to nearly 28.5%. (Which I argue is still better than a fixed deposit)

So what’s the catch? Dividends will be taxed for non-equity funds, as if they are your income. Plus, there’s a dividend “withholding tax” – a sort of Tax Deducted at Source – 10% for residents (for >10K dividend), 20% for NRIs and companies.

That makes dividend income equivalent to a fixed deposit, where you get paid a certain amount of interest every year and the bank holds back 10% as TDS. It also makes life more cumbersome – you now need TDS confirmations for each non-equity mutual fund (dividend option) that you hold. (Luckily, now the system is automated, so your TDS credit is visible online. Register here.)

Impact: Growth Plans will make more sense to the investor. Even if you want regular income, just sell regularly, and that gets qualified as either a short term gain or a long term gain depending on how long you’ve held. Short term gains on non equity funds get taxed at your marginal rate too, but have no withholding tax, which is better for cash flow. Long term gains give you indexation benefits for inflation, which is great for debt funds. For a return of 8%, if 6% is inflation, you will pay tax on 2% – again, much better than FDs where you pay tax regardless of inflation.

Example: Take a fund or FD that makes 1% a month, and you put 50 lakhs in it. Assume you’re in the 30% tax bracket.

Investment Interest Withheld What you get

Tax Pd later

Net Return

Fixed Deposit 50,000 5,000 45,000 10,000 35,000
Fund (Dividend) 50,000 5,000 45,000 10,000 35,000
Fund (Growth) 50,000 0 50,000 150 49,850

This is for the first month, since your gain is very little. If you buy 500,000 units at Rs. 10 each, the NAV would have gone up to Rs. 10.1, you will sell 4950 units to get your Rs. 50,000 – that has 49,500 of principal and Rs. 500 of capital gain. Tax at marginal rate = Rs. 150.

As the gains increase, the tax amount goes up, steadily (since now more of the return is gain). But after about 24 months – the longest you need to hold for going into the “long term” bracket – you get the first 6% free of tax due to indexation, and are only taxed on what’s above that (again, at your marginal rate). In the 25th month, the same 50,000 will consist of 10,600 gain and remaining as principal – yet, the long term gain concept keeps that tax at only 2,500. That is far cheaper than the mutual fund (dividend) or FD, where the total tax is Rs. 15,000 every month.

That means: Monthly Income Funds need to be relooked. So does every non-equity fund where dividend was used as an option. With the 10-20% equity kicker in them, they make sense for a reasonable income plan, but the monthly income as dividends will be taxed at a high rate. You might want to use the growth plans instead.

Downside: You need to have the discipline to sell every month, and you’ll need some work in the year to calculate your tax liability. The difference, though, is substantial, even at the 10% marginal tax bracket.

  • Anonymous says:

    >Good Work Deepak,

    In case of MIP, you have an option called STP, where they redeem fix amount and send to you on fix date, far better then dividend pay out option in current regime also (who do not have taxable income).

    Kalpesh Jani

  • Anonymous says:

    Excellent post on debt fund when DTC kicks in.

    But even under the current regime growth option of Debt fund offers similar benefits.

    Only difference is that Debt Funds do not offer guaranteed returns per month.

    I think in India people are very obsessed with guranteed return (both NAV and Dividends) especially retirees etc. So they may not bite the bullet even if the dividends are tax free.

    By the way 10 year Benchmark yields are near 8%, do you think good time to enter Gilt Mutual Fund?


  • Anonymous says:

    >Great stuff, Deepak.

    So whats your take on the taxation treatment of the Benchmark Liquid BEES ETF, considering that the sole form of return is a daily payout of additional units (Benchmark classifies this ETF as a debt fund for taxation purposes)?


  • Deepak Shenoy says:

    >Kalpesh: Thanks – yes, didn't think of the STP bit!

    MK: Yeah, but MIPs were starting to be looked at (the dividend parts). I don't know about 8% being the area to focus on – Gilts have been much much higher, very recently.

    Anon: You're right – the dividend will need to have withholding tax AND will be a mess for taxation – for LiquidBees. Urgh. Didn't think of that!

  • Anonymous says:

    >Dear Deepak,

    Presently Div. Dis. tax on MIPs are 12.5%. If DTC removes this it will be great news for Retirees etc. who wish to buy MIPs.

    But the real driver behind MIPs were stating to be looked at was Broker's commission. I was approached by several Big Houses like HSBC, UTI and Bluechip to invest in MIPs. When I asked Bluechip they told me it is commission. MIP is one of the few avenues for them (apart from ULIPs/Pension Plans/Company FDs) to earn their living and pay their employees.

    So the popularity of MIPs.

  • nithya says:

    >It really amazing…………..

  • krishna says:

    >It really help the people………………..

  • subramoney says:

    >I also saw this and spoke to a couple of big guys in the Income Tax practice. Their take was interesting – they are not sure about the final form in which the DTC will be implemented (if at all). The div being treated as income is a result of bank pressure – it also means the corpus will come down. Corpus coming down will increase costs :(.