The Budget proposal to hike dividend distribution tax (DDT) on debt fund investments to 25% from 12.5% is likely to impact returns given by fixed-income schemes with a dividend component.
The increase in rates is set to affect the arbitrage between post-tax returns in debt funds and fixed deposits (FDs). ?The scope of arbitrage between FDs and short-term debt funds will be significantly reduced. While there won’t be any exodus of money per se, investors might become more choosy and opt for FDs over debt investment as returns of debt products with dividend option will decline,? said Jimmy Patel, CEO, Quantum MF.
The impact will be felt by all non-liquid plans with duration of less than one year, including three-month fixed maturity plans (FMPs). However, market participants rule out significant outflows from these schemes into FDs because of the liquidity advantage enjoyed by the former.
?Banks were losing out to mutual funds because of the differential tax treatment and it is clear that they have lobbied the finance ministry to correct the anomaly,? said a fund manager, on condition of anonymity. ?As it is, retail participation in debt funds is small; with the tax arbitrage reduced significantly, debt funds will become even more unattractive,? he added.
Currently, liquid funds pay a DDT of 25%, while other debt funds pay 12.5% on income distributed to retail investors. Including surcharge and cess, investors pay tax of about 14.5% on non-liquid schemes at present, which means those in the highest tax bracket of 30% can hope for a tax aribitrage of over 15% over FDs. Taxes for fixed deposits are charged at 10%, 20% or 30%, depending on the tax slab that one falls under.
Market participants believe that investors should now look at growth options instead of dividend plans. ?There could be some sort of realignment in favour of growth options,? said Deepak Chatterjee, MD & CEO, SBI MF. He added that it would now make sense for investors to look at a holding period of more than one year as this investment would qualify for long-term capital gains tax computed at 10% without indexation and 20% with indexation. According to Vikrant Mehta, head ? fixed income, PineBridge Investments, the increase in the DDT can encourage retail investors to take a long-term (more than one year) view on their debt investments.
DDT is the tax that debt mutual funds pay on the dividend income distributed to retail investors. Dividends from mutual funds are tax-free in the hands of the investor but fund houses deduct DDT from income earmarked for distribution, and gives the rest to investors.