Debt funds lose some tax edge over FDs

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Debt funds lose some tax edge over FDs

Thanks to the Budget for 2013-14, effective this Saturday (June 1), all retail and high net worth individual (

HNI) investors in debt-oriented mutual fund schemes will have to share a higher burden of tax on dividends they receive. This is because the Budget has increased the rate of dividend distribution tax (DDT) to 25%, plus all the applicable cess and surcharges.

This is a departure from the current rate of 25% that fund houses pay in liquid funds for all retail and HNI investors, and 12.5% in all other debt schemes like ultra short term, short term, income, gilt, MIP and others. The surcharge has also been hiked from 5% to 10%.
So in effect, this year's Budget has done away with the DDT differential that existed between liquid schemes and other debt schemes. And financial planners believe this has been done to neutralize the tax differential that existed between returns from bank fixed deposits (FDs) and most debt schemes.

The hike in DDT has also made equal rates for all types of investors in debt funds. At present, all corporates, including partnership firms, pay DDT of nearly 34%, which includes all the cess and surcharges in all types of schemes. The increase (in DDT) would reduce the returns of debt funds by around one percentage point.

As an investor, you should take note of two things here. Firstly, the dividend that you receive from your investments in debt funds is tax free in your hands. This is because it is the responsibility of your fund house to pay the DDT to the government and then transfer the post-DDT amount to you. Secondly, this change in DDT applies only to debt funds, while all equity funds, which pay securities transaction tax (STT), don't pay any DDT. And in those funds, too, the dividend that you get is tax free in your hands.

Under the increased DDT regime, the effective rate of tax is that the fund house will pay is 22.07%. So if you are in the 20% tax bracket, move to growth option. Or else, that is if you are in the 30% tax bracket, remain in the dividend option in the first year, and then move to growth option with systematic withdrawal plan. This is because when you are in the growth option and remain invested for more than one year, you can avail of the indexation benefits, that is you can reduce your tax burden by linking your gains to the rate of inflation.

Now it works this way: If the rate of inflation is 10% and your growth in investments is also 10%, you do not pay any taxes. So since in the last one year the rate of inflation was 9%, and your investments in debt funds returned 9%, then after indexation benefits, you won't need to pay any taxes if you redeemed or went for a systematic withdrawal plan. However, if your fund returned 10%, then you would need to pay some taxes. Since the calculations for your tax obligations could be slightly tricky, to be on the right side of the law, it is always advisable to get professional help here.

As a result of this change, a lot of people who till now opted for dividend option in debt funds, and MIPs (monthly income plans) would now move to growth option and do an SWP after a year.

A recent research report by HDFC Securities pointed out that, compared to bank FDs, the dividend option in debt funds still remains attractive

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