Insights
Mutual funds: Time to reassess MF investment strategy in light of taxation amendments?
August 10, 2020The last week of March 2020 was nothing short of a nightmare for any equity mutual fund portfolio holder. Investors were more likely of spotting a unicorn than spotting a shimmer of green in their portfolio statement at FY2019-20 year-end!
Fortunately, the new financial year brings about a new beacon of hope, a V-shaped recovery and a new found interest in mutual fund investments. With the radical changes to the dividend taxation regime – which is equally applicable to mutual funds — a revisit to mutual fund investment strategy may be warranted.
Till last year (FY2019-20), dividend from mutual funds received by an individual was exempt in their hands. However, such distributions were subject to tax in the hands of the respective mutual funds. This tax on distributed income, borne by mutual fund houses, ranged from 11.648% (in case of equity oriented funds) to 29.12% (in case of other funds).
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Effective 01 April 2020, distributions by mutual funds are no longer subject to tax in the hands of the distributing mutual fund. Instead, the mutual funds are required to withhold taxes (TDS) in respect of such distributions, which will now be taxable in the hands of the recipient, at their applicable slab rates.
Mutual funds are now required to deduct TDS at 10% (excluding applicable surcharge and cess) on the distributions made to resident individuals. The recipient individual is in turn expected to include such dividend income in their income tax return and pay tax thereon as per the slab rate applicable on them.
This means that the dividend that was subjected to tax at a flat rate of 11.648%/29.12% is now taxable basis the overall income of the recipient, which may range anywhere between 0% and 42.744%!
The capital gains levy on redemption of mutual fund units has, however, undergone no change. Equity-oriented mutual funds, if redeemed within a year, are taxed at 15% and if redeemed after a year are exempt for gains up to Rs 100,000 and taxed at 10% (without indexation) on the surplus. Other funds (not being equity oriented mutual funds) if redeemed within three years are taxed at the applicable slab rates and if redeemed after three years are taxed at 20% (after indexation benefit).
Keeping in mind the broad taxation regime on mutual funds (as discussed above), an individual will have to make a conscious and informed decision of whether to invest in dividend options or growth options of mutual funds, depending on his level of income and his expected period of holding such investment.
Decision making for FY2020-21: Equity-oriented mutual funds
For individuals already paying taxes north of 15%, it’s a no brainer to invest in growth options of equity mutual funds regardless of their period of holding. This is because capital gains will be capped to 10%/15%, whereas dividend will be taxed at their respective slab rates.
For individuals whose personal income is subject to tax at lower rates (less than 15%), it may be better to invest in dividend payout options of equity-oriented mutual funds if the period of holding is less than a year – since the dividend component will at least be subject to a lower tax than 15%. Further, there is no TDS implications on distributions under Rs 5000 by a mutual fund. In case the period of holding is more than a year, since long-term capital gains up to Rs 100,000 is still exempt, it may still be better to opt for growth options of equity-oriented mutual funds.
Decision making for FY2020-21: Other than equity-oriented mutual funds
In case the period of holding is less than 3 years, the tax implication remains the same for all investors regardless of the option chosen. This is because both dividends and capital gains will be taxed at the applicable slab rates of the individual. This comes as a massive blow to HNIs, since the distributions on debt funds remained capped at 29.12% till last year. Going forward, they may have to suffer taxes up to 42.74% on the same income. Accordingly, arbitrage funds, which have a similar risk-reward profile as that of liquid/ money market mutual funds, have become more lucrative as they qualify as equity-oriented mutual funds and are more beneficially taxed.
In case the period of holding is more than 3 years, since growth options have capital gains taxed at 20% after indexation benefits, the same is more lucrative to individuals having personal income taxed over 20%.
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Contributed by: Amit Singhania, Partner; Nimish Malpani, Associate
Disclaimer
This is intended for general information purposes only. The views and opinions expressed in this article are those of the author/authors and does not necessarily reflect the views of the firm.
