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New Mutual Fund Tax rules make dividends less attractive

Union Budget 2020 scrapped the DDT on mutual fund dividends altogether effective from April 01, 2020. Now dividends declared by mutual funds will be treated as regular income and taxed at the marginal rate applicable to the investor.

April 03, 2020 1:03 IST | India Infoline News Service
The Union Budget 2020 made a big move to reduce the burden on the small investor by scrapping the dividend distribution tax (DDT) on mutual funds. This scrapping of DDT will apply to equity funds and debt funds. Here is how they are taxed currently.
Type of Fund Base DDT Rate Surcharge Cess Effective DDT
Equity Funds 10.000% 1.200% 0.448% 11.648%
Debt Funds 25.000% 3.000% 1.120% 29.120%
 (Note – surcharge is at 12% of base rate and cess at 4% of combined rate)
 
This system had a flaw in the sense that even a retail mutual fund investor in debt funds paying 10% or 20% tax on total income ended up paying 29.12% as DDT. To that extent the DDT was less progressive in nature. So, what is the change?
 
Union Budget 2020 scrapped the DDT on mutual fund dividends altogether effective from April 01, 2020. Now dividends declared by mutual funds will be treated as regular income and taxed at the marginal rate applicable to the investor. To understand that rate, look at the applicable rates of tax on various levels of income.
Taxable Income Base Tax Rate Surcharge Cess Effective Tax Rate
Rs5L to 10L 20.00% Nil 4.00% 20.80%
Rs10L to 50L 30.00% Nil 4.00% 31.20%
Rs50L to 1cr 30.00% 10.00% 4.00% 34.32%
Rs1cr to 2cr 30.00% 15.00% 4.00% 35.88%
Rs2cr to 5cr 30.00% 25.00% 4.00% 39.00%
Above Rs5cr 30.00% 37.00% 4.00% 42.74%
 Source: Finance Act 2020 (New tax formula not considered)
 
Impact on debt fund dividends
 
Debt fund dividends add economic value to an investor if her taxable income is below Rs10L. Above that, the DDT system would have been more economical. They would be better off opting for growth funds, where the tax rate on LTCG is just 20% and the benefit of indexation is also available. For investors looking for regular income, a systematic withdrawal plan (SWP) will be more effective than dividend plan.
 
How will the new tax rules impact equity funds?
 
Clearly, equity fund dividends will now be at a disadvantage compared to the DDT, which was levied at 11.648%. However, the old DDT system had a cascading effecting because the company paying dividends would have already paid DDT. To that extent the effective tax would have been much higher. Nevertheless, this shift in taxation is likely to encourage mutual funds to push sales of growth plans over dividend plans.
 
TDS on mutual fund dividends
 
Till now only dividends paid out to NRIs attracted tax deduction at source (TDS). Effective April 01, 2020, any dividend paid out to a person more than Rs5,000 per year will be subject to TDS at the rate of 10%. This is subject to PAN being linked to Aadhar. In the absence of that, the TDS will be at 20%.
 
The new rules on MF dividend taxation would reduce the attractiveness of dividend plans further and give a big boost to growth plans and SWPs.

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