The Union Budget 2018 has had some major announcements in the area of capital gains on equities and equity funds. From the point of view of equity funds there were two major changes with respect to equity funds as under:
If the long term capital gains (LTCG) on your equity funds during a financial year exceeded Rs.100,000 then the surplus gains above Rs.100,000 will be taxed at the rate of 10%. On these capital gains there will be no benefit of indexation available and this tax will be charged at a flat rate if 10%. The effective rate of tax will be 10.4% after considering the 4% surcharge. Short term capital gains will continue to be taxed as before!
Effective 01st of April, dividends paid out by the equity funds will continue to be tax-free as before in the hands of the investor as before. However, the equity fund dividends will now attract a dividend distribution tax (DDT) of 10% at the point of dividend declaration. Here again, the 4% surcharge will apply so the effective tax rate will be 10.4%. That means if the fund declares a dividend of Rs.10 then the dividend paid out to the fund holder will only be Rs.8.96 only.
Understanding the concept of dividend paid out by dividend plans
What happens when the mutual fund pays out a dividend? Let us look at the difference between the NAV reaction of a growth plan and the dividend plan of the same fund as under:
Particulars of XYZ FundXYZ Equity Fund - GrowthXYZ Equity Fund – DividendType of FundEquity growth planEquity – Dividend payoutNAV on 1st Jan 2017Rs.35Rs.35NAV on 1st Jan 2018Rs.42Rs.421 year returns on the Fund20%20%Dividend DeclaredNilRs.5Post Dividend NAVRs.42Rs.37
There is a slight difference between the dividend declared by a company and the dividend declared by a mutual fund. When a company declares dividend it is an indicator of the liquidity and earnings of the company and hence the company can actually create wealth from that point onwards. In fact, high dividend yields can be a trigger for more value creation. But in case of mutual funds it is a zero wealth creation game. Look at the example above. The growth plan of the same equity fund has a NAV of Rs.42 after 1 year. The dividend plan has paid out Rs.5 as dividend and hence its NAV has come down to Rs.37. The net wealth effect of the dividend is nil. That is always the case with dividend plans of mutual funds.
How this budget changes the pitch for dividend plans of equity funds
As stated above, the latest budget has imposed a 10% tax on dividend distribution by equity funds (DDT), which effectively works out to 10.4% when the impact of surcharge of 4% is also factored in. Of course, this is effective from April 01st 2018. We have seen earlier that dividends by mutual funds do not make any value impact on wealth. However, now that dividends are going to be taxed at 10.4% DDT, the net impact will be more. Let us look at the table below to understand this difference… This is despite the fact that LTCG on equity funds will be charged at 10% on capital gains above Rs.100,000/-.
XYZ Equity Fund - DetailsGrowth PlanDividend PlanNature of the FundEquity fund – growth planEquity fund – dividend payNAV on 1st Feb 2017Rs.10Rs.10Units Held100 units100 unitsNAV on 1st Feb 2018Rs.11Rs.111-year Returns10%10%Dividend payoutNilRs.1Units Redeemed10 unitsNilTaxable Dividend (DDT)Nil10.4% tax on Rs.100 = Rs.10.4Taxable LTCG (1 lakh unused)NilN.A.Taxable LTCG (1 lakh used)Redemption Value Rs.110
Capital Gain – Rs.10
Tax at 10.4% = Rs.1.04N.A.
In the above case the dividend plan entails a DDT of Rs.10.4 whereas when a similar amount is redeemed from the growth plan the actual tax payout is just 1/10th of that entailed in case of the dividend plan. The crux of the story is that after the recent budget imposing the 10% DDT on equity funds, there is a very strong case for investors to shift out of dividend plans to growth plans. It is surely going to be tax efficient apart from being in sync with your long term wealth creation.
From a tax efficiency perspective it makes a lot of sense to switch from dividend to growth option. How to switch from one mutual fund to another is quite simple but remember that it entails a cost in terms of exit loads and tax implications. One needs to factor that in. In case of new equity fund options, it makes a lot more sense to stick to growth plans than dividend plans. Even after considering the tax implications of tax on LTCG on equity funds, it is more tax efficient to stick to growth plans!