Equity Mutual Fund Dividends are taxed 12.942% (not 10%): Here is how to avoid this

Published: February 6, 2018 at 10:17 am

Last Updated on February 10, 2018 at 2:16 pm

Budget 2018 has proposed that equity-oriented mutual funds be subject to a 10% dividend distribution tax (DDT) to ensure parity with the 10% LTCG tax on growth equity mutual funds.  If you include the surcharge and cess, the rate of dividend tax is 11.648% and if you add the effect of “grossing up”, the full tax rate is 12.942%! With many investors using the monthly dividend plans of balanced mutual funds for “regular income”, I discuss how this 12% figure comes about and what should be done to avoid this DDT. Perhaps it may be obvious to many regular readers, but since I have received many questions in this regard, I thought a separate post is necessary to address this issue.

FAQ on Mutual fund dividends and DDT tax

1: What are mutual fund dividends?

A fund houses sell some stocks or bonds and pays out the proceeds to unitholders. When they do so, the NAV of the fund decreases to the extent of the dividend declared.

This is a simple introduction to the subject written with the help of Uma Shashikant: When do mutual funds declare dividends


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2: What is a Dividend Distribution Tax?

This is a tax levied by the fund house before the dividend is given to us. An example will help.

The proposed DDT tax is 10%. Adding the 12% surcharge and 4% cess, this becomes 11.648%. =10%*(1+12%)*(1+4%)

Suppose the dividend received is Rs. 100,

this means, the fund house has taken an amount = Rs. 111.111 and applied 10% tax on it (100/(1-10%) =111.111)

111.111 x (1-10%) = 100 This is known as “grossing up”.

The DDT = 11.111 (that is on the grossed up amt of 111.111)

Surcharge of 12% on this = 12% x 11.111 = 1.333

Add 4% surcharge on (DDT+ Surcharge) = 0.497

So The DDT + Surcharge + Cess = 12.942 (total amount deducted by the fund house before distribution of the dividend = 112.942)

The efect of grossing up is NOT included when someone says net DDT is 11.648%. The actual DDT rate including grossing up is 12.942% 

In other words, Total DDT deducted/Dividend received = 12.942%.

Whereas Total DDT deducted/(Grossed up amount) = 11.648%

3: Equity LTCG up to Rs. 1 lakhs is tax-free, how about dividends?

Unfortunately, any dividend amount from an equity oriented scheme will be subject to the 12.942% tax.

4: how is this fair?

It is certainly not fair to the investor because DDT cannot be reimbursed or offset in ITR, unlike LTCG. However, from an accounting point of view, if LTCG is taxed, DDT is necessary.

5: Is this not a double taxation?

Many people incorrectly believe that equity dividends were tax-free because stock dividends are subject to DDT by the companies and hence double tax is avoided.

This is not true. The dividend distributed by a company has nothing to do with the dividend distributed by a mutual fund. They are independent events and hence can be taxed independently.

6: I hold dividend mutual funds. What should I do now?

Ask yourself if you need the dividends (see below too). If you don’t, then gradually switch to growth mutual funds.  All units older than 1Y old can be switched in one shot before March 31st, 2018. For units aged less than 365 days wait until they become older and then switch. Why? Becuase you will have to pay 15% STCG tax if you switch now. Of course, you will have to pay LTCG tax if (LTCG) and redeemed after 1st April 2018, but 10% tax is less than 15% tax.

7: I thought I will get tax free monthly dividends from mutual funds. What should I do now?

Monthly dividends from balanced funds simply do not make any sense. Switch out as mentioned above. If you want monthly income, do not ever withdraw from a volatile instrument. Remember that dividends are a withdrawal done by the fund house for us (units held will not change but value will decrease after each dividend)

In a volatile instrument, if the NAV fall, you will have to withdraw more units if you have set up an SWP. So never do that either. Switch to growth-oriented equity funds and do not use them for immediate income. You can always redeem an amount with LTCG of <= 1 lakh free of tax to book profits, lower risk etc.

You can use debt (liquid) or arbitrage mutual funds for your income requirements depending on your tax slab, while the rest of the corpus is in growth mutual funds (debt + equity) for future income needs.

8: But I am in 20%/30% slab and Equity DDT is only ~ 10%. That does not seem so bad?

Yes, if you look at only the tax rates. I am looking at the risk to your capital! If the so-called “bloodbath” in the Sensex and US markets continue, you will see what I mean. Those nice “regular” dividends will be the first to vanish.

9: Does this mean dividend equity funds should be avoided in all cases?

In a normal dividend plan, the fund manager books dividend twice a year or maybe once and this is usually when there are enough profits to book. Though those dividends will still be taxed, you are reducing risk from your equity investment. You can hold the dividend and reinvest when the market falls (not a dip, use a proper method to determine a fall). This way you lower risk on your investments. Of course, there is an tax and it is up to you to decide if this is justified or not.

I am quite happy with the introduction of this DDT though and even more happy about the fantastic benefits to senior citizens proposed in budget 2018. The reason being, this will curb mis-selling of monthly dividend plans of equity mutual funds.

Also, I hope people don’t buy monthly income plan dividend options to “get monthly income”. Especially for those in 5% and 20% slabs, that would be plumb stupid considering full DDT tax on debt fund dividends is about 38.827% after including grossing up. Here are some examples: How tax (DDT) affects mutual fund dividends and lowers return (examples)

 

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