Dividend Distribution Tax (DDT) is just another form of tax that levied by government on companies according to the dividend paid to their investors. Normally these dividends paid by Indian companies are tax free in the hand of investors whether out of Direct Equity or Mutual Fund investments. Before such payment of dividend, companies and debt funds deduct DDT from the gross declared amount and rest distribute to the investors. Hence, you as an investor don’t have any tax liability on the dividend income, but technically these dividend incomes are not the actually tax free income that you get. Remember, any dividend incomes from foreign companies are taxable in hands of investor.
Most of the investors whose investment horizon is short term (say less than 12 months) they opt for those investments where they expect to receive regular income by way of dividend so that they will not incur any tax liabilities. Usually Mutual Fund houses provide investments whether Equity oriented or Debt Fund with dividend payout or reinvestment option. Section 10(34) of the Income Tax Act, 1961 declares that in addition to the income tax paid by a domestic company against the total income for any assessment year, any amount declared, distributed or paid by such company in form of dividends, is subject to additional tax known as Dividend Distribution Tax. DDT is also applicable to debt mutual funds and is the tax that debt funds pay on the dividend distributed to retail investors.
Did you know during the budget for FY2013-2014 finance minister has hiked the DDT and also increased the surcharge? Now the effective rate of tax is 28.33% on dividends declared by all categories of debt funds (including liquid funds). This new tax rule is already effective from June 1, 2013. Earlier liquid funds used to pay DDT of 25% (plus surcharge and cess). All other types of debt funds had been paying DDT at 12.5% (plus surcharge and cess) on income distributed to retail investors. DDT paid by all types of debt funds to corporate investors continue to be at 30% with increased surcharge and applicable cess. The surcharge on DDT for all mutual fund schemes has gone up from 5% to 10%.
The below table summaries the changes proposed in the Union Budget on DDT;
How does it impact you?
This increased DDT and surcharge will make dividend options in Debt Mutual Funds unattractive. Because the net post tax return in your hands (as retail investor) from dividend plans would be lower as the DDT charged on the debt funds has been increased from 12.5% to 25% (plus surcharge and cess). Meanwhile, the Growth options in the Debt Mutual Funds will become attractive if you redeem the investments after a year, taking advantage of long term capital gains.
What is still good?
Despite the increased DDT, Dividend plans in the Debt schemes are still attractive for those investors who fall under the higher tax slab of 30%. It still gives higher post-tax returns than any bank fixed deposits. In the Dividend option of debt funds, you have to pay the tax of 28.325% (over short term i.e. holding less than 12 months) while in Bank Fixed deposit, you pay 30.90%. Even in the growth option in debt mutual funds looks even more attractive if the units are redeemed after a year only. Gains thereon are liable to be taxed as Long Term Capital Gains at lesser of 10% without indexation or 20% with indexation plus applicable education cess.
Find below tables analysing the effective yield of a debt/liquid fund comparing to a fixed deposit scheme with holding periods of less than 12 months and more than 12 months for any retail investor.
Scenario 1: Effective Post-Tax Yield in Short Term Investments (less than 12 months)
Scenario 2: Effective Post-Tax Yield in Long Term Investments (more than 12 months)
*For an easy calculation purpose the taxation on the long term debt fund holdings has been assumed as 10.30% without indexation.
With the above comparison, you can very well figure out what needs to be considered before getting into any debt/liquid funds for short term or long term investment horizon. Share your views!