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Budget: Mutual Fund Dividends To Companies at 30% Dividend Tax

Now for an interesting hidden (i.e. not yet spoken about) aspect of the budget.

According to the finance bill, any income distributed by debt funds to companies (or anyone other than an individual) will get hit with dividend tax of 30%.

Earlier the rate was 25% for liquid funds and 20% on other funds. Now it’s all been bumped up to 30%, presumably to remove the discrepancy with fixed deposits.

For a while I thought: Why? If companies choose the growth option, they don’t have to take on dividends – but then, if they sell the growth option funds, they get hit with short term capital gains tax on the gains, which is basically 30% (since it’s added to their income). And to gain any benefit they need to hold the funds for a full year or more (in the growth option) which only a few will do.

Individuals (and HUFs) will continue to pay 25% on liquid funds and 12.5% on other debt funds.

This is a negative for MFs in general; more than 80% of all mutual fund assets are in debt funds. They have been able to provide good returns to companies who have large, but short-term corpuses. If  a company had kept 100 crores for a month in a dividend paying debt fund, and it got in about 8% a year, the post-dividend tax yield would have been 6.4% on which there would be no further tax. A fixed deposit yielding the same 8% would have given them a yield of 5.6%. Now, both options are equal.

Of course, for the short term, current debt fund yields are SO much better that it still makes sense to go with MFs. Short term MFs are yielding upwards of 8% a year, and a one month FD is still offered at 4 to 5%. But that gap should narrow in the next six months.

  • Hemant says:

    >You should be named JASOOS Deepak – always finding hidden things.

  • Anonymous says:

    >The major effect of this will come to the liquid plus (Ultra Short Term) category of funds. These funds by nature of being of a little higher maturity enjoyed the status of non liquid category and institutions parked money in these on the grounds of tax arbitrage. As in a normal liquid scheme they were charged 25% DDT & in these they were charged 20% DDT. Now with the DDT coming at 30% in both the categories i.e liquid as well as non liquid, the tax arbitrage advantage is gone and so from a point of view of parking money the institution will be indifferent between these 2 categories and if at all they come to mutual funds to park money i.e. they find that 30% DDT attractive than other avenues, then they will go for the liquid schemes as by very nature, these schemes provide almost similar returns as liquid plus schemes with almost no volatility and a portfolio maturity of 3 months or lesser.

    This clearly signals death of the liquid plus (Ultra Short Term) category of funds.

    Also it will be required to be seen if the institutions now favour Short term Funds and even income funds & FMPs as an investment vehicle. These category of funds being non liquid in nature also gave institutions the tax advantage and FMPs were specially favoured as even with the locking feature the differential vis a vis a FD was immense. This differential now stands nullified as far as FMPs are concerned as on both FMPs & FDs the institutions will be taxed at 30% + surcharge. So all the AMCs which used to thrive on institutional plans on their FMPs with lowest brokerage and highest yields may have to rethink or even close such plans in their FMPs. Now only retail money will flow in these FMPs. This will be particularly true for shorter tenure FMPs than the longer tenure FMPs. As in longer tenure FMPs a growth option will still attract LTCG at 20% tax rates.

    Also on longer tenure funds though the effect is difficult to gauge at this point in time, as in them investment usually happen on a view on the rate cycle and to make capital gain rather than tax advantage. Tax advantage was an additional benefit. So in this case if there is a compelling view on the rate front, then the institutions will surely come in as the capital gain which they make would nullify the tax effect at least if it is a tactical investment of less than a years horizon.