What are the nuances of taxing dividends on equity and debt funds - Motilal Oswal
What are the nuances of taxing dividends on equity and debt funds - Motilal Oswal

What are the nuances of taxing dividends on equity and debt funds?

How do mutual funds reward you as an investor? There are broadly two ways. Firstly, you get rewarded by the growth in the NAV. This is akin to price appreciation of equities and over the longer term this is useful as it auto compounds your investment. The other method of rewarding investors is through the regular payout of dividends. These dividends can only be paid out of profits made and not out of capital. Also, funds cannot assure dividends to investors as per SEBI regulations. To understand dividends, the most important aspect is how they are taxed. That largely depends on whether the fund in question is classified as an equity fund or a debt fund. Let us understand tax on dividend from debt mutual fund and mutual fund dividend tax treatment in detail. Let us also look at whether dividend from mutual fund is taxable or exempt in India?


How are equity funds and debt funds demarcated as per SEBI regulations?

The problem of demarcation becomes critical because there are equity funds with a debt component and there are debt funds with an equity component. Then there are balanced funds which deliberately mix equity and debt. How is the demarcation decided under these circumstances? Tax status of mutual fund holdings is based on whether a fund is classified as an equity fund or as a debt fund. If 65% or more of the AUM is invested in equities then it is classified as an equity fund, otherwise it is a debt fund. Of course, the SEBI regulations define what time period is to be concerned and at what points of time such mix has to be maintained. Therefore, under this definition, equity diversified funds, sector funds, thematic funds, arbitrage funds and even balanced equity funds are classified as equity funds for tax purposes. On the other hand, bond funds, liquid funds, credit funds, MIPs, FMPs, ultra short term funds are all classified as debt (non-equity funds) for taxation purposes. Remember that all Fund of Funds (FOFs) are classified as non-equity funds for tax purposes even if it is a fund of equity funds. That is an anomaly that continues to this date.


How are dividends on equity funds taxed?

Mutual funds typically offer three types of plans; growth plan, dividend payout plan and the dividend reinvestment plan. The taxation of dividend payout plans and dividend reinvestment plans are the same. Since growth plans don’t payout dividends this aspect is not applicable to them. The dividend plan pays out dividend to unit holders out of the profit generated by the fund. The rule is that dividends can only be declared out of profits and not out of capital. Actually dividends are value neutral because when a fund declares a dividend of Rs.4 per unit, then the NAV of the unit falls proportionately by Rs.4. The difference lies in the tax implications of dividend!


Dividends from equity funds are tax-free in the hand of the investors. However, effective the Union Budget 2018 (i.e. effective April 01st 2018) there is dividend distribution tax (DDT) that is payable on these dividends. When an equity fund declares dividends, a dividend distribution tax (DDT) of 11.648% (10% tax + 12% surcharge + 4% cess) is deducted and only the net amount is paid out. One can argue that there is no tax on dividends in the hands of the investors but it is largely one and the same. To the extent of the DDT, the dividend in the hands of the investor reduces.


How are dividends on debt funds taxed?

Like in the case of equity funds, debt funds can also pay out dividends only out of the returns generated. That means; dividends can only be paid out of interest received by the fund on the bonds or out of capital gains generated by trading in these bonds. Here is a point to remember. There is nothing like assured dividends when it comes to mutual funds (even it be debt funds). Investors tend to get misled by names like Monthly Income Plan (MIPs) and FMPs, but even these funds can only indicate the approximate dividend which cannot be construed as an assurance of dividends.


Like in the case of equity funds, debt fund dividends are also tax free in the hands of the investor. However, they attract much higher rates of DDT compared to equity funds. When a debt fund declares dividend, DDT of 29.12% (25% tax + 12% surcharge + 4% cess) is deducted and net amount is paid out.


It is normally this higher rate of dividends on debt funds that pushes a lot of investors towards systematic withdrawal plans (SWP), which happen to be a more scientific method of planning your taxes using debt funds. In a SWP, the entire corpus of the investors is invested in a debt fund and gradually and systematically depleted over a number of years. This withdrawal has a principal component and a capital gain component and that makes it more tax friendly for the investors.

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