Investors have got a setback with the finance minister’s move to tax dividends, despite the revised sops. A question uppermost in their minds is whether mutual funds continue to be a rewarding and tax efficient investment vehicle as was the case earlier.

Who has been hit the hardest?
First lets see who have really been affected by the decision to tax dividends in the hands of investors beyond the 80L limit. Post-budget, we spoke to Mr Sarvana Kumar (Head of Fixed Income, SBI Mutual Fund) who commented, ‘More than 90% of inflows into liquid funds as well as more than 60% inflow into income funds as well as gilt funds comes from corporates as well as HNIs (high networth individuals).’ Evidently this move is most likely to hit corporates and HNIs.

What about the retail investor?
As far as the retail investor base is concerned, its pure debt funds and MIPs (monthly income plans) that account for the largest chunk of investments on the fixed income side. (Retail investors also have significant exposure to growth funds but the dividend taxation problem is not as acute mainly because they are taxed in the investor’s hands at flat 10% regardless of his tax bracket.) Undoubtedly, taxing dividends will mark an end to those good old days when you got to keep all the dividends. There is a Rs 9,000 limit under 80L for mutual fund dividends, but a lot of investors have both fixed deposits and mutual funds and Rs 9,000 is too little to matter.

A silver lining
However, there is a silver lining for retail investors who would like to continue receiving the income stream with minimal tax outgo. And for this they need to thank the innovative fund houses that have started functioning with a service-oriented perspective to provide the best options to their investors. Obviously maintaining and increasing their net assets is the other consideration for the fund houses.

Why is the dividend option not attractive any more?
Dividends are taxed in the hands of investors as they constitute income. Going forward, the dividend income beyond Rs 9,000 will be taxed depending on the investor’s tax bracket. For investors in the highest tax bracket who have exhausted their Rs 9,000 80L limit, a Rs 10 dividend payout will leave them with less than Rs 7 (@31.5%). To investors in the lowest tax bracket, the dividend option is still attractive.

What are fund houses doing to get around this?
Fund houses have worked around this by converting dividend income into capital gains. They have done this by allowing investors to withdraw a pre-determined amount (and even variable in some cases) at regular intervals (monthly, quarterly, half yearly) from their principal account. It’s more popularly known as the systematic withdrawal plan (SWP) and is the exact opposite of systematic investment plan (SIP).

How is the SWP more efficient than the dividend option?
The SWP and the dividend work on different principles. Dividend is income and is taxed as such. For instance, for an investor in the highest tax bracket, a Rs 10 dividend payout will be taxed at 31.5% and he will be left at with Rs 6.85. However, an SWP is a redemption and is not considered an income. Therefore it entails capital gain/loss. With an SWP, the entire SWP amount is not taxed, only the difference between the entry price into the fund and exit price.

Let us understand this by way of illustration:
Say Mr Investor had bought 1,000 units of a Mutual Fund at Rs 10 on 30 September 2001. He has applied for SWP at Rs 500 every quarter. His SWP is due on 31 December 2001 when lets assume the NAV is Rs 11. When he withdraws Rs 500, the short term capital gain will work out to Rs 45.5. (refer calculation below).

SWP amount: Rs 500

Units redeemed on 31 December 2001
Amount/NAV as 31 December 2001
500/11: 45.5 units
Purchase cost of 45.5 units (on 30 September 2001): 45.5*10: Rs 455

Short Term Capital Gain
500-455: Rs 45

Amount taxed
45@31.5% (highest tax bracket): Rs 14.2

Net amount in investor’s hands
500-14.2: Rs 485.8

Now let assume the same investor had invested in the dividend option of the same fund and had got a dividend payout of Rs 500.

Dividend: Rs 500

Amount taxed
500@31.5%: Rs 157.5

Net amount in investor’s hand
500-157.5: Rs 342.5

Compare the tax paid and net amount with the investor under both options:

	Tax Paid (Rs)	Net amt with investor (Rs)
SWP	14.2	485.8
Dividend Option	157.5	342.5

So the move to tax dividends need not be a setback for you as we have illustrated above. To put it simply mutual funds continue to be more tax efficient (with the SWP) vis-à-vis other comparable investment avenues and they continue to give returns far superior to their peers. And you, the investor, can continue to laugh all the way to the bank with your mutual fund investments.

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