As a result of Budget 2020’s decision to tax dividends at slab rates, the value of mutual fund dividend plans has plummeted by half in the last year. In a circular issued on October 5, the Securities and Exchange Board of India (Sebi) asked mutual funds to rebrand their dividend plans as “income distribution cum capital withdrawal” “from April 1, 2021.”
The purpose of the regulator was to highlight the unique nature of mutual fund payouts, which differ from what most people think of when they think of dividends: profit distribution. Dividends from mutual funds can simply return your capital, requiring you to pay taxes on both the investment and the gains. According to statistics from Value Research, a whopping 1.79 trillion remained waiting in mutual fund dividend programmes as of September 30, despite the unfavourable tax situation.
The issue with mutual fund payouts is that they have two flaws. Unlike stock dividends, they are paid from both your capital and profits. As a result, you will receive a dividend as a return on your investment. Beginning in FY21, this dividend will be taxed at slab rates, resulting in a tax payment on your capital.
Here’s an example of what I’m referring to. Assume a mutual fund begins with a ten-dollar net asset value (NAV) and grows to fifteen dollars. You put $15 into a mutual fund, and it climbs to $17. The fund has already booked all of its earnings and announced a $7 payout, but its NAV has plunged to $10. You, the investor, will receive not only your investment profit (two dollars), but also five dollars of your own money. The entire dividend amount (7) is taxed at your slab rate, even though your true profit is only $2. (which might be as high as 30 percent ). According to Sebi standards, mutual funds are allowed to declare dividends from their realised gains. These profits, on the other hand, could have been produced before you joined the fund, so they aren’t technically yours.
“The basic logic of dividends was the zero dividend distribution tax (DDT) on them prior to 2018, which contrasted favourably with the 15% short-term capital gains (STCG) tax on capital gains in mutual funds for holding periods of up to one year,” said Vijai Mantri, co-founder and chief investment strategist at JRL Money, a mutual fund distribution firm. “This tax arbitrage was minimised with the establishment of a 10% DDT in the 2018 budget.” The 2020 budget, on the other hand, renders them taxable at slab rates, thereby putting an end to the use of MF dividend options,” he said.
Assets in mutual fund dividend plans decreased from approximately $4 trillion in September 2018 to 3.6 trillion in September 2019, then decreasing to around $1.79 trillion in September 2020 as investors shifted from dividend to growth plans. “We’ve switched all of our clients away from dividends and toward an SWP” (systematic withdrawal strategy). Dividends declared by mutual funds in 2020 are projected to be limited as well. “Right now, there’s no need to choose MF dividend choices,” Mantri stated.
Investors who are still involved in dividend-paying mutual funds should consider whether they want to remain doing so.