Are dividend yield funds more tax efficient than stock dividends?

Investors had often complained that DDT was unfair because the promoter and the small shareholder forfeited the same proportion by way of DDT.

February 06, 2020 11:26 IST | India Infoline News Service
dividend yield funds
Budget 2020 had some initial reasons for cheer as the dividend distribution tax (DDT) on equities was fully scrapped. Instead, these dividends would be included as other income and taxed at the peak marginal rate in the case of individuals and other recipients of dividends. Investors had often complained that DDT was unfair because the promoter and the small shareholder forfeited the same proportion by way of DDT. While the shareholder did not pay the tax, it reduced the dividends payable. The scrapping of DDT on equities marks a considerable saving for small investors.

Did you know the real cost of DDT on equities?

Most investors intuitively believe that the rate of DDT is 15% but there is a catch (actually several catches to it). For example, dividends have to be grossed up before the actual DDT can be calculated. Then you need to apply the surcharge and the cess. How much does all this add up to the DDT? Look at the table below.
Details of Effective DDT calculation Amounts
Basic rate of dividend distribution tax (DDT) 15.00%
Grossing up base for DDT (15 x (100/85) 17.65%
Surcharge applied at 12% on gross rate (17.65x1.12) 19.77%
Cess applied at 4% of the above amount (19.77x1.04) 20.56%
This is the effective DDT that is applied when dividends are distributed and when the company pays out Rs100 as dividends, only Rs79.44 actually reaches the investor. But the bigger argument against DDT was that a promoter holding 30% stake in the company and receiving crores as dividends was applied the same DDT rate as the small investor holding just 100 shares of the company.  This made the DDT unfair and regressive. To that extent the shift to the new system of taxing dividends at the peak marginal rate in the hands of the investor will be relatively fair and also progressive in nature.

Super rich investors have a lot to worry from dividend tax

Super rich persons earning more than Rs2cr have a serious problem to worry about. Their dividend incomes will now be taxed at the peak marginal rate including the surcharge and cess. Let us look at the case of two super rich individuals and what effective rates their dividends would now get taxed at. Let us assume that X has annual income of Rs2.20cr and Y has annual income of Rs5.20cr. Both of them receive Rs8 lakhs as dividend income from their shares per year. Here is how the calculations will look.
Particulars Effective Tax Rate for X Effective Tax Rate for Y
Total annual income Rs2.20cr Rs5.20cr
Annual Dividend Income Rs8 lakhs Rs8 lakhs
Base incremental tax rate 30% 30%
Surcharge applied 25% 37%
Cess charged 4% 4%
Effective marginal tax rate =
(30 x surcharge x cess)
39.00% 42.74%
Effective tax on Dividends Rs3.12 lakhs Rs3.42 lakhs
Post tax dividends Rs4.88 lakhs Rs4.58 lakhs
The bottom line is that in case of the super rich in the high income category (earning more than Rs2cr per annum) nearly 40% of the dividend received will have to be given away as tax in the new dividend tax regime. How to avoid this situation?

Arbitrage between dividend yield stocks and dividend yield funds

One way investors can avoid this steep tax on dividends is to shift from dividend paying stocks to dividend yield funds. Opt for a dividend yield mutual fund instead that has a portfolio that approximately replicates the equity portfolio. Select a growth plan and then let us see how the two options look at the end of one year in post tax terms.
Particulars Holdings in equity shares Holdings in dividend yield  funds
Total annual income Rs5.20cr Rs5.20cr
Portfolio Value Rs3.50 cr Rs3.50cr
Annual Dividend paid Rs20 lakhs N.A.
Annual Capital Appreciation N.A. Rs20 lakhs
Base Exemption N.A. Rs1 lakh
Tax rate applied 42.74% 11.648%
Total tax payable Rs8.55 lakhs Rs2.21 lakhs
As can be seen from the above comparison, by opting for the growth plan of a dividend yield fund instead of investing in direct equities, the investor ends up paying just 1/4th the amount of tax. This saving in tax becomes more relevant to the super rich tax payers earning more than Rs2cr per annum as the surcharge will make the dividends extremely tax-unfriendly. Of course, a dividend yield fund cannot be a direct substitute for a dividend yield stock, but it can at least be substantially more tax efficient. As we saw in the table above, that makes a substantive difference.

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