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Aarati Krishnan

BY DOING away with the distribution tax on dividends paid by mutual funds and shifting the responsibility for paying income-tax to the investor, the Budget 2002 has significantly reduced the effective returns from dividend-paying mutual fund schemes. Investors are likely to suffer greater tax incidence on dividends distributed both by debt and equity oriented mutual fund schemes. The tax incidence will be lower only if the mutual fund dividend is deducted under Section 80-L. Otherwise, it will be equal or, in most cases, higher.

Debt funds: Debt funds were earlier required to pay a distribution tax of 10 per cent on all dividends distributed by them. They will now be required to pay no distribution tax. But the dividend received from a debt fund will be included in the total income of the investor and thus be subject to tax at the prevailing income-tax rate applicable to him. Earlier, all investors in debt funds, irrespective of their tax bracket, bore the same tax incidence of 10 per cent on dividends from debt funds. Now, investors in the 20 and 30 per cent tax brackets will face a higher incidence of tax.

Since the Finance Minister has mandated a 10 per cent tax deduction at source on dividends distributed by MFs, investors will have to bear a tax of 10 per cent on dividends received from mutual funds, irrespective of whether they disclose the dividend in their income-tax return.

Lower effective returns: The changes could significantly reduce the effective yield from debt funds for investors in the higher tax brackets of 20 and 30 per cent. For instance, a 12 per cent dividend from a debt fund earlier translated into a pre-tax yield of 17 per cent for investors in the 30 per cent tax bracket. But now, the pre-tax yield is at 12 per cent. Debt funds will be left with larger distributable surpluses due to the waiver of distribution tax. But this may allow them to peg up their dividend rates only marginally.

Earlier, the tax-free status of dividends from debt funds meant that even the modest performers among debt funds generated a reasonable yield for investors on a tax-adjusted basis, in comparison to other investment avenues, such as company fixed deposits, bonds or small savings schemes.

Now, with dividends from debt funds being put on a par with company FDs and bonds for taxation purposes, investors need to re-evaluate the attractiveness of the debt funds they hold in their portfolio and could consider switching to the better performing funds. While doing this, it is necessary to bear in mind that the high returns generated by debt funds over the past year are unsustainable, and prompted entirely by the sustained rally in the bond markets. Over the next year, returns from debt funds may stabilise at historical rates of 9-10 per cent.

While re-evaluating debt funds, investors need to keep two factors in mind. One, they carry a higher level of risks than a portfolio of fixed deposits of triple A rated companies or term deposits with banks; they would therefore have to offer a risk premium of at least 1 percentage point over these two alternatives, if they are to make good investment options. Two, for investors who place a premium on liquidity, open-end debt funds are still the best investment option, compared to other investment avenues available in the debt market.

Growth option more tax-effective: Investors who prefer to remain invested in debt MFs and make their investment tax efficient, could consider opting for the growth option offered by debt schemes. Since returns on the growth option are subject to long-term capital gains tax (if units are held for more than a year) at 10 per cent, the growth option suffers lower tax incidence than the dividend option. While the dividend option pays out returns from the fund in the form of payouts, the growth option accumulates the returns earned by the fund in the form of appreciation on the fund's NAV.

Investors who would like a regular income stream from a debt fund or those who would like to capitalise on a particular period of high returns from a debt fund, can opt to redeem a certain portion of the units in the growth option each year, ensuring a regular flow of income.

Such an arrangement would also give an investor the flexibility to vary his drawals from the fund, according to his needs at various points in time. For investors who prefer to automate the process, several fund houses offer systematic withdrawal plans that enable investors to leave standing instructions with the fund to draw a certain sum from the fund each year, through redemption of units.

Equity funds to be taxed: Open-end funds with 51 per cent or more of their net assets invested in equities have enjoyed concessional tax treatment over the past three years. Dividends distributed by such funds have been exempt from dividend tax over this period.

Now, the Finance Minister has made dividends from equity funds taxable in the hands of the investor at a concessional tax rate of 10 per cent. The concession will, however, be applicable only for the year 2002-2003. After this year, dividends from equity funds will also be subject to income-tax at the rates applicable to an individual investor.

The decision to tax dividends distributed by equity funds could discourage funds from paying out the generous dividends of the past three years. However, the depressed equity market conditions have already reduced the large dividend payouts by equity funds in the recent times.

The dividend payouts by equity funds have had the undesirable effect of attracting corporate and high net-worth dividend-strippers to equity funds for short periods of time. Temporary parking of funds with an equity fund has the potential to impact the returns for the staying investors in the fund. The imposition of dividend tax could put an end to this undesirable practice.

However, dividend payouts from equity funds have also served as a sort of circuit-breaker mechanism. The pressure to pay out dividends has ensured that equity funds encash on market rallies at periodic intervals, helping unitholders lock into returns that may not be sustainable over the long term.

For instance, if equity funds managed to tot up respectable returns over the past three years, this is partly because the generous dividends distributed by them in 1999 and 2000 helped preserve returns during the bear market of 2001. Had they remained fully invested in equities, investors may have suffered a sharper erosion in NAVs.

The depressed equity market and the newly imposed dividend tax may discourage most equity funds from declaring liberal payouts on their dividend options from now. However, investors can still create a "dividend effect", by setting target returns for their equity funds and redeeming a certain portion of the units once the target is reached. This will ensure that an investor capitalises on a market rally, even if the fund manager does not.

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